Could “Open Banking” solve UK banks’ ROE crisis?

Bank returns on equity (RoE) have been tightly squeezed over the past decade. The cause? A concerted push by regulators to prevent a re-run of the financial crisis, forcing banks to hold more capital to make them less likely to fail. Pre-crisis, UK banking was a high-growth, high-ROE industry. But regulators no longer allow the high leverage that underpinned these high returns.

The good—if counter-intuitive—news for banks is that new regulation is about to usher in a new era where returns could turn sharply higher again.

Our recent report, Open banking – How to flourish in an uncertain future, outlines how this regulatory initiative, which mandates the sharing of customer transaction data, could have a truly transformative impact on the traditional retail banking model. The advent of what we have termed “marketplace banking” could increase industry returns.

“Marketplace banking” opens up the possibility of a new, capital-light, business model. Some operators could operate as online marketplace platforms, similar to those that have flourished in other industries, like retail. Such operators could earn fees from listing financial services providers on their banking marketplace where end customers can browse and buy financial products from a range of providers. The risk and capital liabilities will largely remain with product providers, lessening the capital required of the marketplace.

There will, of course, be challenges around regulating these ‘marketplaces’, such as over shared risk liabilities. Nonetheless, these fee-based operators have the potential to earn very high, and consistent, RoEs, driven by high margins and asset turnover, rather than by leverage. We have imagined a broker’s note on just such a banking marketplace, People’s Finance, here.

Compare the RoE breakdown of a leading consumer goods marketplace with that of a leading bank, and the contrast is clear. Both operators enjoy high margins. But while the bank’s solid RoE is boosted significantly by high leverage, the bulk of the marketplace’s premium RoE comes from high asset turns.

Closer to home, in financial services, another equivalent for a banking marketplace is the fund platform (or ‘fund supermarket’), which provides funds from multiple asset managers to customers, earning fees from them for access to customers, as well as from customers for account administration. The ROE composition of a leading fund platform looks much more similar to that of a marketplace than to a traditional retail bank, driven by high margins and asset turnover.

Return on equity (%), asset turns and leverage ratios of a leading bank, marketplace and fund supermarket, 2016

Given the high level of consumer trust and brand awareness that will be required by new entrant looking to operate as a pure banking ‘marketplace’, we believe these players will be few and far in between, and they will enjoy premium returns.

We also believe that as incumbent banks start offering products by third-party providers on their platforms, they could see significant RoE enhancement. They have the opportunity to levy ‘access fees’ on their own platforms, and these fee revenues should come with much lower capital requirements.

While the potential deployment of some deposits into investment products could disrupt some cheap deposit funding, banks can, if they so choose, earn RoE-rich fee income from these (likely newer and more numerous) product providers. This will be all the more useful in the current low interest rate environment, which is putting downward pressure on net interest margins, as it will allow banks to earn an income stream relatively independent of the direction of interest rates.

For banks, depending on the extent to which they open their platforms, the RoE impact could be transformational. True, banks will need to drive significant cultural change and invest in new technology to reap all the rewards. For those that do, marketplace-related revenue could boost RoEs as much as two to three-fold compared with the existing banking business.

We believe the ultimate outcome for banks is likely to be a hybrid between the marketplace and the status quo. Thus, while banks will still carry the risk and capital liabilities stemming from their proprietary products, they could earn high margin access fees from other providers, as well as from new propositions. Our imaginary broker analyses the prospect of this innovative bank, Moneysafe here.

Unlike in the past, where RoE improvement depended largely on trends in interest margins and leverage, banks could get a very useful lift in their ROEs from capital light fee income: a very welcome shift.

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