Getting back in shape
20 March 2018
The global banking sector has been through a painful, but necessary, adjustment over recent years. Capital ratios have increased materially, helped by a combination of higher core Tier 1 equity holdings and a reduction in risk-weighted assets. In practical terms, this means banks will be better able to absorb losses should the economic environment take a turn for the worse. Similarly, we have seen clear improvements in liquidity, with loan-to-deposit ratios falling across the sector. This makes banks less reliant on fickle short-term market funding, which can quickly evaporate. Finally, there has been progress made on some legacy issues, with non-core asset disposals progressing and litigation expenses having peaked (although restructuring costs continue to rumble on). Throw in a sharp improvement in the global economic backdrop and regulators seem to be feeling pretty happy about the short-term prospects for financial stability.
While this good news story is well documented, there are still legacy issues in the financial sector that have yet to be fully resolved. For example, while progress has been made on non-performing loans, these still remain high in certain jurisdictions, particularly in parts of the Eurozone. Other drags on profitability include the low interest rate environment in certain markets, such as Japan. This, alongside high levels of competition and concerns over business models, continues to depress margins. These caveats aside, the broad picture around the sector looks relatively healthy. Indeed, it will be interesting to see if we start to see a more powerful credit impulse over the coming years against a backdrop of stronger growth, accommodative monetary policy and improving profitability. If so, recent history will tell us to watch carefully for signs of building imbalances. More robust regulatory frameworks across most regions should help ensure that growing exuberance does not get out of hand. Moreover, policymakers have a range of macroprudential tools to help address any potential imbalances. The US could prove a possible exception, if a signalled change toward an easier interpretation of regulatory rules reaches too far. Similarly, stalled progress on a Eurozone banking union, or bank profitability in Japan, could see familiar stresses emerge further forward if the economic tide turns.