1. What is universal banking? Why is it that, in recent years, universal banks seem to be performing worse than specialist banks?
A universal bank is a financial services conglomerate that combines retail, wholesale and investment banking under one roof and reaping synergies between them. There is no standard definition for what qualifies as a universal bank, but simply banks with a 50/50 revenue split between investment banking activities and retail banking activities. Examples are Deutsche Bank, Citigroup, HSBC, Bank of America Merrill Lynch, JPMorgan and Barclays.
Lately, universal banks have been performing worse than specialist banks with lower ROE and price to book ratios, indicating that cost currently exceeds the benefits of this banking model. Reasons for this include expensive regulatory changes after the crisis, and operations in unprofitable areas, which I will explain in detail now.
There have been several regulatory changes after the financial crisis. Before, big banks enjoyed an implicit guarantee of the government to bail them out in case of failure. This led to moral hazard because the customers took this into account and thus did not monitor the bank and price the risk accordingly. These banks, therefore, enjoyed a cost advantage from this. However, after the financial crisis changes have been made to neutralize the potential harm of the failure of large banks and the implicit guarantee from being too-big-to-fail. For example, with G-SIB buffers (Global systematically important banks), ringfencing and resolution. G-SIB buffers are extra capital requirements for more systematic banks, where the most systematic ones are Citigroup and JPMorgan 2.5%, followed by BoA, BNP, DB; HSBC. As universal banks tend to be regarded as more systematic than specialist banks, this regulation leads to higher capital regulations for them, which is costly as it is a relatively expensive form of funding. Furthermore, the restructuring of the bank’s organizational charts due to ringfencing and resolution have been an expensive activity.
Moreover, a possible factor could be that specialist banks to a more significant degree tend to have core areas where they have a competitive advantage, while universal banks are operating in many areas where competitors are better (Bloomberg, 2016). Furthermore, the Bloomberg article states that many universal banks information-management systems are not efficient in evaluating the profitability of their range of businesses, and therefore continues to operate in areas that are not positively contributing to the enterprise value. On the one hand, a broad range of serving is attractive to customers who want one bank to fulfill all its banking activities, and there might be beneficial to keep some activities regardless of who they might be unprofitable by themselves. At the same time, if the loss of these divisions individually is greater than the benefits of offering customers all sorts of activities, this results in universal banks performing worse.
With regards to debt, one might expect the more balanced business model to be perceived as less risky, and the universal banks to, therefore, enjoy better terms when raising debt, but this does not seem to be the case. Universal banks like JPMorgan, Citigroup etc. tend to have a single A rating from S&P500, which is the same as specialist banks as for example Goldman Sachs, and Wells Fargo (Financial Times: Lex in depth, 2015). Furthermore, they do not tend to have much lower prices of credit default swaps. According to “FT: Lex in depth, 2015” the reason might be because of the added risks of complexity and opacity.
Although there are the abovementioned costs, there are also benefits of this model. A potential advantage is economies of scale and scope, especially with regards to funding and to covering costs of compliance and IT (Financial Times: Lex in depth, 2015), branding and risk management; network effects that attract customers; and broad geographic and sectoral diversity (WallstreetJournal, 2016). Additionally, potential benefits are informational advantages and cross-selling. However, in conclusion, nowadays the benefits of universal banking do not seem to compensate for the costs of being present in many different markets. Furthermore, even though there are exceptions to this overall trend, for instance with the performance of JPMorgan, a Goldman report showed that breaking the bank up would create value (Reuters, 2015), and accordingly proves that the universal banking model is not beneficial for them.
References for questions 1:
- Bloomberg.com. (2019). Bloomberg – Are you a robot?. [online] Available at: https://www.bloomberg.com/opinion/articles/2016-01-27/why-universal-banks-are-failing [Accessed 30 Jan. 2019].
- Ft.com. (2019). Lex in-depth: Universal banks | Financial Times. [online] Available at: https://www.ft.com/content/a21b7454-d243-11e4-ae91-00144feab7de [Accessed 1 Feb. 2019].
- Ft.com. (2019). Regulators test the universal banking model | Financial Times. [online] Available at: https://www.ft.com/content/bfd7389a-9cc7-11e4-a730-00144feabdc0 [Accessed 1 Feb. 2019].
- Ip, G. (2019). Big Banks Have Risks—and Benefits. [online] WSJ. Available at: https://www.wsj.com/articles/big-banks-have-risksand-benefits-1460564960 [Accessed 1 Feb. 2019].
U.S. (2019). Breaking up JPMorgan could lift its stock price, Goldman analyst says. [online] Available at: https://www.reuters.com/article/us-jpmorgan-research-breakup/breaking-up-jpmorgan-could-lift-its-stock-price-goldman-analyst-says-idUSKBN0KE1M220150105 [Accessed 1 Feb. 2019].
2. What are the comparative advantages and disadvantages of challenger banks? Give some examples of this type of institutions.
Challenger banks have many comparative advantages. First of all, they have better abilities for IT adoption with less complex IT systems and fewer legacy problems. As technology is changing they can implement technology improvements quickly and cheap as they do not have to pay high amounts to update large systems, like the bigger banks with their complex legacy IT environment. Furthermore, challengers have fewer conduct fines and thus does not have to bear the high costs of serving these. This is something many bigger banks are still serving, because they have been punished with this after regulatory violations conducted in the crisis.
Additionally, in a lot of cases, they have fewer branches which hold cost down and results in lower cost to income ratios. Already in 2014, people accessed their mobile banking apps 2500% more times than they visited branches, and this has been increasing rapidly since then (BBA, 2014). Before mobile banking and technology improvements, branches were much more necessary for the banking business, and this expensive entry cost served as a considerable barrier to entry that is now removed. Challengers have a significantly lower amount of branches, the average number of branches for banks 1461, larger challengers 334, smaller challengers 37, and large retailer 167 (in reality much higher cause they have leaflets in most of their branches) (KPMG, 2016). The challenger Starling Bank has avoided the high costs of opening new independent branches by partnering with Post Office and thereby gaining access to all its locations.
Furthermore, big retailers do not bear the costs of introducing new branches as they use their stores for leaflets distribution. An exception to how most challengers have fewer branches is Metrobank, whose core focus is to be present with many branches.
Smaller challengers also tend to attract customers from being easier to understand by providing few products, often in niche markets, and have a high focus on transparency. They often focus on niche markets like on SME lending or retail-lending, markets where the larger banks are believed to underserve customers and thus customers have an incentive to switch to a better alternative if challengers can provide this (KPMG, 2015). Moreover, their streamlined and automated operating models allow them to more quickly adapt to customer feedback, market trends, and innovations.
Additionally, by being newly established, they have the opportunity to clearly create a fresh image in a customer group that has no impression of them beforehand. This way they can have a clear brand image, and personalize it to their niche client base. An example of this is how Revolut has a clear statement of purpose where they speak directly to a specific niche customer persona that has a global lifestyle. However, it must be mentioned that this does not apply for the big retailers, as they already have high brand awareness in the market.
Lastly, with regards to funding in terms of equity the high growth prospectus lead to book multiples much higher than what the established banks have experiences (KPMG, 2015).
Challengers also experience some disadvantages. With the exception of the GSIB-buffer, regulatory costs are higher for smaller banks. This is because complying with all the banking regulations entail some fixed costs as well as some variable costs that depend on size and complexity. To the extent that the fixed costs are essential, regulation can disproportionately affect smaller banks. Banks that are larger in size can be more cost-efficient in terms of regulation, for example with mandatory reporting and disclosure, and can then use an internal rating-based approach instead of the standardized approach to capital requirements which typically yield lower capital requirements. Employing the IRB approach demands for IT, expertise and years of historical data on loans to be able to work out expected loss and probability of default on loans. These factors hinder the challengers from being able to use this IRB system which can generate very different capital weighs, potentially requiring as little as a 6th of the requirements of standardized weights (BBA, 2014). The disadvantages with this are largest when it comes to safer assets, and therefore challengers tend to end up with loan portfolios that are riskier, and which therefore can be difficult to recycle efficiently (BBA, 2014).
With regards to funding, several advantages may be in place for the bigger banks, for instance, they might to some degree still have a cost advantage from being too big to fail. Moreover, their position as being more well-known can come with an impression of being safer which gives them higher risk-ratings and thus higher costs of funding. Furthermore, the bigger banks are usually the ones that government deposits are placed with, and this is a very low-cost type of financing that would be beneficial for the smaller challengers to have (BBA, 2014).
Furthermore, all banks need access to the payment systems CHAPS or BACs to be able to give their customers the ability to make quick payment transactions. However, to gain access to these banks must either build a system to access the payment systems directly, which has high fixed initial cost, or access them through a third party agency, which is expensive as the third party will then charge a higher amount than the price of directly accessing the payment systems (BBA, 2014). Challenger banks usually use third parties to access these payment systems, and this becomes very costly for them, compared to how the bigger banks already have direct access to these.
Examples of challenger banks:
Challenger banks can be classified into Smaller Challengers, Larger Challengers, Large Retailers, and Digitally Focused challengers. Of these smaller challengers are banks that have typically been around for 5-10 years and were initially backed by PE firms, however, five of them are currently listed banks (KPMG, 2016). Examples are AIB UK, Aldermore, Shawbrook, Secure Trust Bank, Close Brothers, Charter Savings, Metro, OneSavings. In detail, one example os Metrobank which focuses its business model around branches which it calls “stores.” It has more than 50 of these, and they are open seven days a week. They are therefore focusing on one specific business strategy by operating in the branches area where the big banks are scaling down. However, one of the main reasons customers do not prefer communicating with the big banks through branches is that they usually can not execute/get any services immediately in the branches, but can only order a service. This makes it time-consuming as they must then come back later to for example pick up the credit card they have ordered etc. Metrobank branches, on the other hand, can execute different actions like printing of credit cards, etc, on request of the customers within the short time that they visit the branches. Therefore, the bank provides a service the big banks do not. This strategy has shown profitable as they finally earned money in 2017. The balance sheet of the bank is straightforward and traditional; they hold few securities and their business is mostly lending to customers.
Furthermore, another example of a challenger bank is Monzo which is an app-based bank with more than 750 000 customers that focus on fee use in foreign countries, keeping track of your spending and simplifies the process of sharing bills. Lately, it has also started offering overdrafts, and have gained a full-banking license with deposit insurance on its current accounts. The bank is not yet profitable, which is similar to the performance of different challenger banks in the first years of operations. It must though be mentioned that they are showing improvements, for example, the cost of running an account have reduced with 80% the last ten years, and the losses are decreasing from year to year, and was very small in 2017. They need to find a way to draw revenue from assets, as they are not currently charging for their services, despite the overdraft charge of half a pound per day for an overdraft. When it comes to Monzo’s balance sheet, it is straightforward and traditional. Add more info om tid
Furthermore, Larger Challengers tend to have characteristics that are closer to the big five than the smaller challengers. They have typically been established for longer (KPMG, 2016). Examples are First Direct, Paragon, Bank of Ireland UK, Clydersdale, Williams & Glyn, TSB, Virgin Money, Nationwide, Handelsbanken. Moreover, large pre-existing retailers use their extensive network of stores for leaflets distribution as they have access to a substantial number of customers (KPMG, 2016). Examples are Tesco, M&S, Asda Money and Sainsbury’s. They all provide unsecured products and savings accounts, while Tesco and M&S additionally offer current accounts and mortgages.
Lastly, digitally focused challengers are using technology and focus on personalization as key differentiators to attract customers with (KPMG, 2016). Examples are Atom, Fidor Bank, Mondo, Starling, and Tandem. Of these, Atom, which was founded in 2014 was the first one to enter the banking market with being solely on the phone, and offering a range of both personal and business banking products (Atombank, 2018). The marketing strategy is focused on the customers and letting them be in charge. It focuses on simplifying banking processes and being time-saving for the customer who can log in by using face and voice recognition. From then on they can be served 24/7 by the customer service team, and can do perform operations at the time they find most suitable for themselves. The bank has raised money five times, to a total of £369 million in funding (Crunchbase, 2018). The bank has not yet shown to be profitable.
References for question 2:
- Anon, (2019). [online] Available at: https://www.crunchbase.com/organization/atom-bank#section-funding-rounds [Accessed 3 Feb. 2019].
- Assets.kpmg. (2019). [online] Available at: https://assets.kpmg/content/dam/kpmg/pdf/2015/06/challenger-banking-report.pdf [Accessed 3 Feb. 2019].
- Atombank.co.uk. (2019). All about Atom, the mobile-only bank that works for you | Atom. [online] Available at: https://www.atombank.co.uk/about-us [Accessed 3 Feb. 2019].
- Bba.org.uk. (2019). [online] Available at: https://www.bba.org.uk/wp-content/uploads/2014/06/BBA_Competition_Report_23.06_WEB_2.0.pdf [Accessed 3 Feb. 2019].
- Mead, W. (2019). A new landscape: Challenger banking annual results | KPMG | UK. [online] KPMG. Available at: https://home.kpmg/uk/en/home/insights/2016/04/a-new-landscape-challenger-banking-report-2016.html [Accessed 3 Feb. 2019].
- UK Parliament. (2019). Brexit may offer opportunity to improve competition in banking – News from Parliament. [online] Available at: https://www.parliament.uk/business/committees/committees-a-z/commons-select/treasury-committee/news-parliament-2015/eu-referendum-competition-in-banking-chairs-statement-16-17/ [Accessed 3 Feb. 2019].
3. What is ring-fencing? Which activities need to be inside the ring-fenced entity, and which activities need to be outside of it?
Structural reform, also called ring- fencing is a regulation that requires major UK Banks to separate core retail banking activities from their investment and international banking (activities undertaken in non-EEA entities) by January 2019. The objective is to protect the core services (retail and small deposit-taking) provided by the banks from risks in the investment bank and global financial markets and ensure that if a large bank fails these activities will experience minimum disruption (bankofengland, 2016). To oblige with this regulation, banks had to stop undertaking or divest these activities or to restructure and place these activities within separate legal entities. This, therefore, demands the banks to go through a lot of changes and restructuring which can be very costly.
This is done to improve the resilience in case of problems and reducing the need for bailouts, with the ultimate goal of promoting financial stability. It is developed in response to the global financial crisis. This applies to banks with more than 25 billion in retail deposits, thus meaning the five largest retail banks: Barclays, Lloyds, HSBC, Santander, and RBS, which means that once implemented three out of four of every pound of retail deposit will belong to a ring-fenced bank.
Activities that must be performed within the ring-fenced body are retail and small deposit-taking in the United Kingdom or elsewhere in EEA. These activities will be subject to requirements which ensures that they are safer and less likely to fail. In addition to the regulatory requirements concerning capital and liquidity that the banking group as a whole must meet, they have regulatory demands on their own as well. The ring-fencing policy demands for independent governance, so they make decisions independent of the rest of the banking group. To ensure this, the chair and at least half of the board must be independent non-executive directors, and no more than 33% can also sit on boards of groups in other parts of the bank.
Furthermore, the RFB is restricted from outsourcing activities to the investment bank. However, as alternatives, they can outsource to other RFBs, group service companies or approved external suppliers from outside of the banking group. Lastly, to the best of their ability, RFBs are demanded to participate directly in the main payment systems they use, instead of indirectly going through another bank to gain access.
Activities which must be performed outside of the ring-fenced body, meaning they are referred to as prohibited/excluded activities, are trading and selling securities, commodities, and derivatives, exposures to financial institutions other than building societies and other RFBs, operations outside the EEA, underwriting securities, buying securitizations of other financial institutions.
Throughout the process, the plan and banks implementation of it, have been closely followed by the Prudential Regulatory Authority and the Financial Conduct Authority who developed the specific rules and details of the ringfencing requirement. All banks were able to implement the changes on time. In the future the PRA will monitor the bank’s compliance with the regulation, and implement changes when needed, to ensure the ultimate goal is served to the best possible extent. This authority should do so by paying obdurate attention to, and acting to reduce, risks originating elsewhere in a banking group that can affect the RFB. They should also make sure that decision-making in the RFB is conducted entirely independent of banking activities outside of it. They should also, in general, make sure the RFB is as independent of other members in the financial group as it could be, which then enables them to carry on even if other parts fail. Moreover, the FCA will assess how ring-fencing impacts the protection of consumers, market integrity and competition, and ensure that the regulatory scheme overall mainly has a positive impact on these areas (BankofEngland, 2016).
References for question 3:
- Bankofengland.co.uk. (2019). [online] Available at: https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2016/ring-fencing-what-is-it-and-how-will-it-affect-banks-and-their-customers.pdf?la=en&hash=E272AEC4AFA815AEAA55E4197B8B2AEFF8221F1A [Accessed 28 Jan. 2019].
4. Why is governance in banking different than in other non-financial firms? What are the roles of the Board of Directors?
Furthermore, non-financial firms have few, and often just one significant debtholder who might demand to sit on the board whiles banks have many sources of money as their debtholders include depositors, subordinated debt-holders, and wholesale creditors, and they do not sit on the board under normal conditions. While non-financial firms often have their debtholder/s on the board, banks do not have this under normal circumstances. Furthermore, as there are many smaller deposit holders they can be participating in free-riding where they trust that everyone else is monitoring, and therefore do not do so themselves (Newyorkfed, 2011). Moreover, debtholders represent more than 90% of the balance sheet of banks vs. 40% on the balance sheet of a non-financial firm (Newyorkfed, 2011).
In general, the safety and soundness of banks are much more important for the economy as a whole than other non-financial firms, and they are essential to financial stability. This makes it more important to hinder the failure of banks than of other non-financial firms. Furthermore, the business of banks is not opaque and can change very quickly. Banks can alter their risk composition more quickly than non-financial firms.
The board of directors is the primary stakeholders influencing corporate governance. The board should appoint the top officers, like the CEO and other members of senior management, monitor that they act by the set policies, and strategy (including risk appetite) that is set by the board and critically assess the information they provide. The board should continually evaluate the performance of the management and how capable they are of providing a good job and replace them if necessary.
Furthermore, they should decide on remuneration policies to best make sure they align managers incentives with the incentives of shareholders; thus, facilitate long-term objectives and aligning risk-appetite. Moreover, they decide on dividend policies, and every year the board of directors holds an Annual General Meeting (AGM) where they report the performance of the completed year and the plan for the future (Brefigroup, 2018).
When it comes to risk appetite, management and control the board should be active in determining the banks risk appetite by considering the strategic, capital and financial plan (Bis, XX) and portrait this in RAS. The RAS should be easy to understand, and it should be clear how it should be implemented when conducting decisions in the bank’s daily operations. To be clear and straightforward, boundaries and considerations that the management and workers of the bank should consider in procedures should be clearly laid out. The board should make responsibility clear for all individual parties including business lines, the risk management function, the compliance function, the internal audit function, and monitor their performance and ability to carry out their responsibility. Furthermore, the board should have a compliance function, with the mission of overseeing how the management follows the guidelines and standards set when it comes to risk.
To have good corporate cultures and values are essential to ensure ethical and legal activities are carried out on all levels of the organization. The senior management sets clear standards, and therefore both the selection of top officers and ensuring their awareness of the importance of legal frameworks and setting clear values and making sure they are communicated through all levels of the organization. The board should ensure that the board’s value provides for unfavorable behavior and activities to be brought to management in reasonable time, that the code of conduct is of high quality and adequately followed in each division. There should also be a clear awareness of the negative consequences that will follow the violation of set rules and standards.
The board of directors is responsible for the organization of its work and practices, to implement committees, and periodically review the structure to ensure it is as effective as possible. More specifically, the chair of the board has the primary responsibility for the effectiveness of the organization of the board. The board could appoint different committees to focus on specific areas. Examples are the audit committee which creates the system for internal audit and financial reporting, as well as overseeing it and interacts with both the internal and external auditors. The risk committee should decide on, and monitor compliance with; the banks risk appetite, and capital and liquidity management. The compensation committee is in charge of remuneration, and the corporate governance committee is in charge of overseeing the suitability of the current management and evaluating changes which can be beneficial, and the ethics and compliance committee who ensures compliance with rules and regulations and that the banks have means that promotes ethical and legal decision-making, and the HR committee.
Moreover, the board of directors should oversee all policies implemented by different committees, etc and identified potential conflicts of interest and decrease/remove them. Examples of conflicts of interest that can arise inside universal banks are that they underwrite securities for low-quality borrowers due to the naïve investor hypothesis, or that they push cross-selling irrespective of client’s interest, for example as done with hiding PPI within contracts with customers. Lastly, the board should facilitate the internal audit function to serve its purpose of creating high-quality governance processes and survival of the bank for the long-term.
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