Banks set for a challenging 2011

The global financial crisis, followed quickly by a deep recession, has already meant plenty of change for the UK's banks and we can expect the wind of change to continue to blow across the banking sector in 2011.

There are several key challenges facing the sector at the current time:

- firstly there is the proposed levy on the sector,

- secondly there is the formation of an independent banking commission to look into the possible separation of retail operations from investment banking operations,

- the third challenge revolves around higher capital requirements and the effect on M&A activity,

- lastly there is the question of bankers' bonuses.

The banking sector levy

This was introduced at the start of this year and is designed to raise £2.5bn a year. Despite being an unwanted cost to bankers, the main problem with the levy is that it is not being internationally coordinated. Potentially this leaves financial centres that are not imposing a levy somewhat better placed than the City of London. This has therefore raised a bigger worry over the UK banking sector's long-term competitiveness. Inevitably the levy did not go down well in the City, with Standard Chartered, Barclays and HSBC all implying that they may even quit the UK. This concern could become more acute as 2011 progresses because of the second key challenge facing the industry.

Independent banking commission

Implementing a separation of retail operations from investment banking operations could force the same three lenders to make huge structural changes. The commission is due to reveal its findings in September. Depending on its conclusions, this could further encourage some lenders to relocate overseas. In a recent speech at London Business School, the head of the commission, Sir John Vickers, appeared to move away from proposing a total separation of the two operations, but he does remain keen on some degree of separation. This could involve ring-fencing retail banking operations, thus requiring them to be capitalised on a standalone basis. However, extra capital for ring-fenced operations will involve extra costs, which is bad news for bank profitability, bad news for the banks' overall competitiveness and bad news for businesses wanting to borrow, given that it constrains lending and forces banks to hold more funds in forms which do not generate a particularly attractive return.

Capital requirements and the potential effect on M&A activity

The capital requirement proposals recently agreed via Basel III could have a direct effect on M&A activity in two ways. On the one hand, higher capital requirements for banks means that companies looking to make acquisitions will potentially find funding scarce and expensive. On the other hand, the phasing in of the Basel III rules could drive increased transaction activity in the financial services sector itself, as the rules will force banks to raise more equity. This will be achieved either by raising additional equity from shareholders and/or by disposing of non-core assets.

A study by the Basel Committee at the end of 2010 showed that the biggest global banks currently fall short of the new requirements by some Euro 577bn! Although UK lenders comfortably meet the new Basel minimum requirement of 4.5% of risk-weighted assets, it is widely expected that the UK regulator will implement a tougher level of 9% to 10%. The Swiss regulator, for example, has already set its minimum level at 10%.

So where does all this leave companies seeking to raise capital to fund M&A activity in 2011? There is currently little optimism about a significant M&A bounce back this year. Research appears to show that activity in 2010 was some 60% down on the peak of the market in 2007. Although banks are under increasing pressure to lend to businesses, when it comes down to individual lending decisions, they remain very selective. Deals will have a higher proportion of equity given that debt multiples have fallen, frequently to less than three times earnings.

Bankers' bonuses

Finally, there is the challenge of bankers' bonuses. A Financial Services Authority (FSA) code has recently been finalised that largely mirrors tough guidelines from Europe's banking supervisors committee. These guidelines envisage the cash part of bonuses being capped at as little as 20% of the total value, with the remainder to be paid in deferred share awards that can be cashed in years later. This stance is much tougher than in rival centres in Asia and the US and is hardly an ideal way to encourage the world's best bankers to remain in or move to the City.

Conclusions

Sitting alongside all of the above, economic conditions are also of critical importance to lenders. When times are bad, borrowers default, bad debts rise, loan demand dries up and bank earnings suffer. In 2010 the UK's cautious economic 'recovery' has helped lenders to get back on their feet. Credit quality has improved as economic conditions have at least stabilised. So the final big question facing the sector this year is whether the gradual recovery can continue. This, above all, could most affect how 2011 pans out for the banking sector.

In conclusion, it is evident that 2011 promises to be an interesting one for UK banks.  

Contact us

If you want to discuss this article further then give our corporate finance team a call on 01908 662255 or contact us via email on mhcfinfo@mhllp.co.uk