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Economic fundamentals are strong, the regulatory climate is favorable, and transformation technologies are more effective than ever before. Now is the time for the banking industry to rethink transformation and pursue long-term strategic change, say Deloitte’s Val Srinivas, Scott Baret, and Anna Celner.
“Before the financial crisis it was almost a bit of a peanut butter approach, where the banks did everything for everyone and everybody realized that model's not the most stable. It's not the way to have the greatest customer experience that you can possibly have.”
—Scott Baret, Deloitte US Banking and Capital Markets Practice leader
TANYA OTT: Want to give customers a great experience? Specialize in something and do it really, really well.
I’m Tanya Ott and I’ll take my PB&J with a side of banking and capital markets. That’s what we’re talking about today on the Press Room. I’ve got Val Srinivas, Anna Celner, and Scott Baret teed up to give us the outlook for 2019. Scott leads Deloitte’s US banking and capital markets practice. Anna’s based in Zurich and leads the global capital markets practice. And Val is a research leader at Deloitte’s Center for Financial Services in New York. They've written a new report which sounds very optimistic. I challenged Val to convince me.
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VAL SRINIVAS: The banking industry, 10 years after the financial crisis, is on more solid ground on a number of fronts. First of all, profitability is very high, especially for the US banks. Maybe Anna can speak to what's happening in Europe. And the regulatory environment is a bit more relaxed compared to right after the financial crisis. So the shift is more towards how do you maintain transformation and how do you continue the progress made on a number of fronts, including switching business models and how you operate and so on. But overall, the banking industry is on firmer ground. And this should provide the ammunition for future growth.
TANYA OTT: So, the banking industry is on firmer ground, but you did allude to the fact that it may not be the same everywhere. Anna, what is it like around the rest of the world?
ANNA CELNER: It actually differs quite substantially by region, particularly in comparison with the US banks that recovered from the crisis relatively quickly and responded to the regulatory demands, restructured themselves, and now, with changes in the tax and economic environment in US, are actually growing very fast and bringing new profitability and [are] expanding globally as well. The situation in Europe is dramatically different. The markets have not recovered as well. There's much slower pace for implementing regulatory change. We don't have one common regulator across all the markets within Europe. There are structural deficiencies and fragmentations within the market structure, from the regulatory perspective, but also political perspective. I would say there is overcapacity in terms of number of banks. We have very low [or] negative interest rates in Europe, which impact bank profitability and their ability to recover, implement regulatory programs to the full extent, and then focus on what they need to do to regain profits and grow. So there are many different issues that are at play in Europe than in the US.
And then there is Asia, where again we have a huge number of emerging large Chinese banks dominating the continent and at some point perhaps expanding beyond China. Chinese banks are subject to regulatory regime as well. There is a huge focus on the conduct, on compliance. But again, slightly different focus from the local regulators than in other regions.
TANYA OTT: Let me back up a minute and rewind us to the United States. The Federal Deposit Insurance Corporation (FDIC) closed 465 failed banks from 2008 to 2012.1 And that was compared to just 10 over five years leading up to 2008. Scott, is one of the reasons that US banking is doing better because US regulators were more aggressive in their intervention?
SCOTT BARET: Yes, Tanya, that's spot on. That is the primary reason generally people say that the US is probably a year and a half to two years ahead going through all these structural reforms. The regulators here really did make all of the US banks take their medicine with regard to the different guidelines that they put in place around capital, around stress testing, all these things actually to make the banking system stronger. And the other part too; if you roll the clock forward from the points that you raise to where we are now, just with regard to the results that came out for the US banks in the fourth quarter and annually—they have record earnings across a broad spectrum. That's not insignificant. And another interesting item that we looked at too is, if you look at the six largest banks in the US, which are also global banks—between Bank of America, J.P. Morgan, Morgan Stanley, Goldman Sachs, Citi, and Wells—their earnings exceeded US$100 billion for the first time. So clearly, they are on firmer ground. The point that we raise in our outlook is that now is the time to pursue that strategic change that we're grounding our outlook on.
VAL SRINIVAS: The economic environment in the US, compared to Europe, has also been more favorable recently. Plus, the tax cuts have been a huge catalyst for bank earnings in the last year. So, there are both the economic and the tax policy effects that you're seeing for the US banks.
TANYA OTT: Deloitte economists have said there's a 25 percent probability of a recession in the US in 2019.2 How does that factor in?
VAL SRINIVAS: The market is adjusting slowly to the potential reality. As of now things look pretty positive, but you do see some signs of the economy slowing down in some sectors. The farming sector in the US is suffering quite a bit from trade tariffs and what's happening internationally and so on. There are some patches of the US economy that are beginning to show some signs of stress. And any economic expansion [has to eventually] come to an end and this is one of the longest expansions we have seen in recent history. So, I think banks are wise to prepare for this eventuality. Maybe it won't be a significant downturn, but a potential dip is to be expected either later this year or next year.
ANNA CELNER: And just to expand on this point … the uncertainty, recession-wise or Brexit-wise, or any political change in the environment is actually affecting all the banks globally in different ways from different perspectives. What has changed since the crisis is not only the stability of the banks, but also the relative scale of banking institutions. We have giants in the US and big banks emerging in China. In Europe, in comparison, it’s much smaller scale than before the crisis. The significance of this is, number one, the profitability that we talked about is driven by tax and interest rates and also ability to pivot from the focus on regulation and compliance to technology and investments in more effective and efficient operating models that will sustain profitability over a longer period of time. So, in this context, while US banks might be faced with potential recession, at the same time having large-scale operations and having regulations largely behind them, they can focus on their operating platforms, taking advantage of the technologies that are emerging and prepare even more resilient operating models to deal with any future recession or challenges that may come from the macroeconomic or political aspect.
SCOTT BARET: If we look at what the banks have done almost uniformly is that they more or less have chosen to specialize in areas. Obviously, there's all the banks that are doing consumer lending and commercial lending at a macro level, but when you take that down into the specific areas where you might have a competitive advantage, the banks are actually doing that and that's the reason why we have, at least from the US bank perspective, the stability in earnings. They are picking their spots, to Anna's point, looking at technology, looking at their operating models, and becoming very efficient at what they do. Whereas before the financial crisis it was almost a bit of a peanut butter approach, where the banks did everything for everyone and everybody realized that model's not the most stable. It's not the way to have the greatest customer experience that you can possibly have. All those things, as you mentioned, are favorable for making this next pivot—into more of the technology to further enhance the operating models, further enhance the efficiencies in which they do that, and further enhanced customer experience.
VAL SRINIVAS: We did a paper on bank specialization a few years ago where we laid out that for banks to survive and thrive in the new post-crisis environment, they have to specialize. And to your point, US banks probably have done that better than European or other banks, and we see the results of those strategies today where the US banks are much stronger.
TANYA OTT: Anna, do you think maybe the European banks and other global banks are just a couple of years behind on that?
ANNA CELNER: From the perspective of embracing technology, all the banks, whether they want to or not, are forced to start implementing or taking advantage of technologies. In particular, technologies such as cloud adoption and [having] a very strong focus on data, preparing the environment to take advantage of the data of modern technologies to serve customers the way they want to be served. So, whether they are in Europe, in the US, or in Asia, all of the banks are focused in modernizing their infrastructure by adopting new technology and fixing the challenges that they have with their data in their own environment. Until the banks adopt new technologies and fix their data environments, they will not be able to create solutions fast and with the quality level required by their customers. They will not be able to integrate external sources of data. They will not be able to serve the client and compete with their peers, who might be one step ahead. It is not a question of if or when. It's a question of how fast.
TANYA OTT: Libor (London Inter-bank Offered Rate) is going away soon and this is a pretty dramatic thing for the industry. Val, can you explain what Libor is and then give us a sense of why this is such a big issue?
VAL SRINIVAS: Libor is the benchmark rate that's referenced in millions of possible transactions across the world. Trillions of dollars, hundreds of trillions of dollars worth of assets and securities are tied to Libor. Basically, Libor is based on subjective estimates of banks regarding interbank borrowing or lending, depending on how you look at it. It's a reference rate that's used widely for any number of securities transactions and products globally. And the change in the reference rate would have significant implications for all kinds of products, not just the banks but [also] companies that raise debt or even consumers who get their mortgages based on these rates.
TANYA OTT: Why is that going away?
VAL SRINIVAS: It's going away for several reasons. One is the fact that there were some scandals post crisis in relation to how these data on interbank rates were collected. The regulators are keen to avoid any reoccurrence of those events. Number two, it's a subjective estimate. It's banks providing an opinion on what the rate is going to be based on what's happening that particular day. It's not based on anything tangible, per se. It’s also what is called unsecured. It’s basically banks lending to each other without any kind of secured funding behind that.
TANYA OTT: And what’s it being replaced with?
SCOTT BARET: This is sort of the curious part as to where we are right now. There’s a number of different industry groups that are involved in trying to pull this all together. So, there’s a common industry approach that’s sort of in the early stages. The US has the ARRC (Alternative Reference Rates Committee) that has a working group around these things, and there are a few different rates that are going to be utilized. The Federal Reserve is sponsoring a rate now, called the secured overnight funding rate. There's one in Sterling right now. There's one in Switzerland. There's one in Tokyo. All of these are just a start. And people understand that there are not only multiple reference rates in different currencies, but there's also different maturity.
All those things are slowly starting to emerge right now. And then as those rates begin to take hold, they'll start a market. They'll begin to be get quoted and then you'll phase away Libor or you'll reset all those Libor contracts that exist right now based on the agreement with the counterparty to one of these new reference rates. But, as you mentioned, there's a bunch of work that has to happen in order for this to take hold, [which] the industry is still trying to figure out now.
TANYA OTT: This sounds so complicated. Go ahead, Anna.
ANNA CELNER: What is really at the core of this is to bring integrity and trust into the market when it comes to those reference rates.
SCOTT BARET: Anna's spot on, because keep in mind, transitioning to anything new presents risk and uncertainty. And you're doing this globally. This is not an easy industry task that has to be done and managed well.
TANYA OTT: It does sound very complicated and like a very potentially risky proposition. Anna, I want to circle back to you on the Asian markets. I was really curious because you talked very briefly about Chinese banks growing very large and very prominent globally. Are Chinese banks looking to take a crack at the US market?
ANNA CELNER: Chinese banks are absolutely giants within their own market and subject to their own regulations. As they are building up, as they are growing and expanding, they are clearly looking at all the other markets globally. So, yes, they have operations around the world, and it's just a question of time before they will grow even bigger outside of their home countries. But currently, they still have massive priorities in their own internal markets. It's a question of time. Maybe not yet, but they are absolutely growing externally. If you look at the promises of industrial China into other parts of the world, it is supported by the banking system and Chinese giants. They're definitely expanding, probably first aligned with the economic and industrial expansion of China.
TANYA OTT: Scott, you're sitting in New York City. You're looking at US banking. What would be the potential impact of if Chinese banks were to look to expand here?
SCOTT BARET: Well, they actually are. All of the major Chinese banks do have operations in the US. Some of those are branches, some of those are representative offices, but they're very much within the US market, not only serving Chinese multinational firms that are operating in the US but also serving US banks as well. So they actually become another lender, another opportunity for competitiveness in the markets. It's actually a good thing overall to have that expansion taking place.
TANYA OTT: We've been talking about what's happening in markets around the world. We've been talking about technology. In early 2018, you were using the phrase “symphonic enterprise” as a way to think about all of this technology coming together and reimagining the way the industry works. Let's close out with your big thoughts on that. Obviously, a lot of technology is geared towards the customer experience. What are you anticipating that we'll see on the tech side?
SCOTT BARET: You're right, Tanya. When we looked at it in 2018 we highlighted what I'll call a patchwork of systems that were out there—platform, software, and different tools. All these different things that were very much legacy infrastructure. And that's always been a key challenge, because keep in mind that the data element that we spoke about before runs through there. But consider the availability of technology that exists right now, the proliferation of public cloud, and what cloud can do in terms of your operating model. It’s actually quite interesting because now you can really think about how you can transform that business, how you can tech-enable it. But to do that, you really do need to get the strategy people, the technology people, operations people all together across the different domains within a bank to really think about the direction that you need to go. That's why we're kind of looking at this as the symphonic enterprise, to think about that broadly and differently. There's been also the emergence of platforms and how you participate in those platforms—whether banks can develop their own platform that can host other types of technologies that customers might be more attracted to, or maybe banks can take their own offerings and products and host those on different technology platforms that exist. The way we look at it right now, there's really no better time to glue these pieces together and monetize that to the benefit of the organization. And that's the mosaic that we see evolving right now.
VAL SRINIVAS: To add to what Scott said, technology changes are happening in the broader context of transformation. How do you transform your business model? How do you transform how you operate? How do you change the way you serve your customers and so on? Technology is an enabler to this massive transformation that you see in the banking industry today. But to a large extent, it depends on the segments you pick. A lot of it has already potentially happened in retail banking, for example, in the customer-facing areas of interactions and so on. Not so much in the back end. This technology transformation needs to happen end-to-end, front customer-facing to back-office processes and so on. Especially in segments such as corporate banking or investment banking where the back-office systems are archaic, old, etc. They need to be modernized as well.
ANNA CELNER: While technology is absolutely critical and we are changing the prerequisites for creating solutions that our customers, especially on the retail side, crave, it's data and the right way to handle the data, both internal data of the bank and also augmented by external data sources, that’s important. So, figuring out the data architecture, the data privacy, [and] the ways to manage and monetize the data will be critical in the future. I also wanted to add to that the environment is changing. The availability of technology and the power of technology is changing and the pace of that change is increasing. What it means is that the ability of the enterprise, the ability of the bank, and the expectations of the customers are growing very fast. The pace of change and the expected pace of change have huge indications also on us humans, both employees and the talent that needs to drive the change. We need to embrace technology. We need to embrace a new way of operating. We need to acknowledge that it's not just going to be employees of the institutions of the bank working to serve the client. There will be external parts of delivering services, whether contractors or external ecosystem players. Some of the processes and some of the interactions might be automated, too. So, how does one construct the future of work for delivering services to the clients that consist of different elements—human and nonhuman collaborating and working well together in a symphonic enterprise context? The impact on the talent—the future of work, the future of the workforce—is dramatic as well.
TANYA OTT: We've talked a lot about retail banking. We've talked about corporate banking. One of the primary business segments that we haven't really touched on yet is wealth management. What is the outlook in 2019 and moving forward when it comes to wealth management?
SCOTT BARET: What we see there is it's one of the best-performing businesses for banks globally. There are very positive macro trends overall. Demographic trends that are also adding to this optimism around the maturing populations globally. And there are opportunities for the broader banking industry there, but one of the things that they really do need to get in front of are the other types of technology companies that are also in those same areas, that are offering the advice on top of the platforms that the banks have. It's an opportunity for the banks to rationalize their role in that, but also an area where they can form interesting technology alliances to benefit from.
VAL SRINIVAS: Right. Digitization and digital advice platforms are having a significant impact on how advice is delivered to clients. What is going to happen with digitization of advice is it's going to be embedded in almost all services and products. As a result of technological changes, customer expectations, etc., the bigger macro theme that is probably yet to play out is pressure on pricing. As the costs of delivering advice comes down with these digital platforms and you have new competitors coming in offering low prices, what is it going to do to traditional pricing in the wealth management industry? You already see some of this happening with some mutual funds and such with no-fee accounts and so on. There is a broader macro trend that could really reshape the competitive dynamics in the wealth management industry globally.
ANNA CELNER: There are additional dynamics [at play]. On one hand, we have pricing pressures and digital and robo-advisor solutions. We have millennials asking for more digital-enabled experiences, driving the threshold of advice, demographically, to the younger people. At the same time, on the other side of the spectrum we have highly sophisticated, personalized and very diverse advice to ultra-high-wealth individuals who have complex needs and for whom trust and loyalty is a very significant value. They may not be even interested in trading off the level of relationship that they have with their bankers to the high-speed, digital efficiency-priced models. So, there are two segments in the wealth management spectrum—the ultra-high net versus the less affluent. And demographically, as millennials and people in their 30s and 40s grow their wealth and become more ultra-high-wealth individual customers of the bank, their preferences and their needs might also be changing. The implication of this for the wealth management industry is that they may have to look at retaining their customers, retaining trust, but also delivering products and services that are more comprehensive in nature, that are addressing needs that go beyond pure financial products or financial solutions, that address the life cycle aspect of their clients. So, digitalization—yes, it’s important. Innovation—yes, it’s very important. But there are many aspects of the global services that wealth management are delivering to the ultra-high-net-worth individuals spectrum of the clients that may not be affected as fast as or disrupted as fast as they are in the retail banking markets.
TANYA OTT: So, as we close out our conversation today, we've been talking about reimagining markets. Final thoughts. What do you want to leave people with?
SCOTT BARET: With regard to how's the global economy doing and the impacts on that and what banks can do given that set of features, I think you couldn't script a better global economy. There is obviously the uncertainty that we spoke about, but in a rising interest rate environment, with different forms of tax reform that are going to occur and [are planned to] occur outside of the United States, as well as the regulatory reforms happening, and also with this potential downturn that people are thinking about—it's a good time right now in light of what exists with the technology, what exists within fintech (financial technology) firms, to really explore different ways that banks can pursue smarter strategic change than what's been available in the past. When you have all these things at your disposal, now's the time to take advantage of it from our perspective.
VAL SRINIVAS: Related to that is the notion of strategic transformation. Thinking of transformation in a more holistic, strategic manner as opposed to one-off transformation across the enterprise. That kind of approach and philosophy will bear fruit in the medium term to long term, and we need that change to happen—change how you change—for the banking industry to be successful.
TANYA OTT: Thank you for joining us today and helping us better understand some pretty complicated issues and what the outlook looks like for 2019 and beyond.
All speakers: Thank you. Thanks, Tanya. Thank you very much.
I am Tanya Ott. Thanks for listening!
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