UK banks are facing a battle with diminishing returns

Marc Sidwell
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AS LONDON’S top bankers meet for their annual Merrill Lynch conference, upbeat public pronouncements can’t conceal the cloud hanging over the sector’s future. The news that Singapore investment fund Temasek is mulling offloading its £6bn stake in Standard Chartered is a typically gloomy indicator. Standard Chartered, after all, thanks to its exposure to Asian growth, offers a better chance of a decent double digit return on equity (ROE) than other UK banks. If Singapore has decided that even this prospect isn’t tempting enough to hold, what hope for the also-rans?

In June, Boston Consulting Group (BCG) provided an overview of the UK’s banking sector in a global context. It makes grim reading. 2011 saw UK banks with the second worst ROE in the world: four per cent. Only Asian-weighted HSBC and Standard Chartered kept two UK banks in the global top 30 by market cap.

Part of the problem is the bleak economic outlook. The Bank of England’s Financial Policy Committee (FPC) reiterated its advice at the start of the week that banks still need to bolster their capital ratios in the face of possible further deterioration, something which automatically reduces ROE.

But it is also a product of the new post-crisis regulatory environment. A July report from McKinsey evaluated the cost of upcoming regulations and suggested that ROE for retail banking in Europe could be expected to fall on average from 10 per cent to six per cent, with the UK seeing the steepest falls of all, from 14 per cent to seven per cent. Banks that qualify as systemically important on a global scale face a further estimated ROE decline of 0.4 to 1.2 per cent, thanks to the extra capital they must hold.

That puts into perspective Stephen Hester’s remarks yesterday. If RBS steps out of the critical ward at the end of 2013 as Hester suggests, it will be to find itself in a post-apocalyptic banking landscape where its hope of an ROE greater than or equal to its cost of equity (currently 11.5 per cent) is positively ambitious.

The sector can’t expect much sympathy about all this from the regulators. Robert Jenkins of the FPC has said banks shouldn’t chase ROE, which rather conveniently sidesteps the declining prospect of doing so successfully. Barclays’ new chief executive Antony Jenkins showed his desire to play ball by dialling down the ROE target set by Bob Diamond.

But hopes that the sector will reject ROE reckon without the new rules’ unintended consequences. The McKinsey report says “we strongly believe that a rigorous ROE focus... could form a strong competitive advantage for some time to come, before it becomes the industry standard over the midterm”.

Greater ROE focus amid a worsening environment for high ROE both look here to stay. As a result, improving productivity seems more and more to be the only realistic path for banks to follow. And since the regulatory burden calls for ever-more compliance staff – McKinsey has estimated that Basel III could require an extra 200 full-time staff for a mid-size bank – the axe will have to fall even harder elsewhere. It’s bleak for banks, but it looks even bleaker for bankers.