The European Banking Landscape: Tackling the Obstacles to Change
For most banks, business is about looking after other peoples’ money. Loans and deposits books usually dominate the balance sheet. Earnings are often driven primarily by interest rates as many banks pay very little or no interest on deposits. As interest rates in North America, Europe and Asia Pacific have been at depressed levels for over ten years now, the profits of the banking sector have been constrained accordingly.
However, banks in common with other commercial businesses are expected to deliver continuous growth in earnings if they are to satisfy shareholder expectations. Growth opportunities in recent years have come from new markets, such as Eastern Europe; from recovering economies, such as Latin America and south east Asia; and from the economic transformation of India and China. However, these opportunities have come at some risk. The levels of bad debt have been generally exacerbated by chasing these opportunities and banking profits have become further depressed.
The response of many banks has been to attempt to maintain profitability through aggressive programmes of productivity improvement or cost reduction. While such initiatives are a permanent obligation of good management, when they become the main drivers of earnings growth the pool of investment funds tends to become starved. When this happens, the development of infrastructure and systems are the most frequent casualties as programmes are postponed or cancelled. Some banks, additionally, chose to diversify into activities such as investment banking and derivatives but these initiatives have now mostly foundered on a lack of scale and an inability to manage the new risks involved.
Meanwhile, banking in Europe faces new structural challenges. The EU Commission has a political objective to create the conditions of a single market across all economic sectors. For coal and steel this became a reality in 1953 with the Treaty of Paris and pre-dated the Treaty of Rome, which effectively created the EU. Despite this early start, the EU functions today as essentially 25 separate national economies with continual expansion impeding progress towards integration.
The introduction of the euro in 1999 replaced the national currencies of 12 member states (11 at first with Greece following later). However, apart from removing certain foreign exchange transactions at a stroke, it did not address the underlying nature of cross-border trade within the eurozone. As observed by Romano Prodi, the President of the EU Commission, the cost of sending a payment from Genoa to Nice, a distance of 100 km, is ten times greater than the cost of sending the same payment from Genoa to Palermo, a distance of 1,000 km. The clear implication was that politicians should address this. However, while regulation may control the prices banks may charge across the EU it will do little to change the underlying cost drivers of cross-border transactions.
Each of the 12 eurozone member states have developed distinctive clearing practices and there are significant challenges involved in making the systems interface effectively. Today, there are 35 different major clearing systems across the eurozone. Some of these systems are proprietary; some are industry owned; and some are nationally owned. However, not all the barriers to a single eurozone-wide payments processing regime are systems related; tax, excise duty, and physical barriers also impede cross-border clearing.
The current position of the EU, in addressing the issue of cross-border clearing, is simple. It wants the banking sector to develop its own EU-wide clearing systems and to allow open access; it does not consider it appropriate for the EU to fund a new EU-wide clearing system. To encourage the banking sector to respond to the challenge the EU has passed the Regulation on Cross Border Euro Payment to facilitate a Single European Payments Area (SEPA). This requires banks to quote a single charge for clearing payments of any particular type within the eurozone (for payments up to €12,500) irrespective of origin and destination. This limit will rise to €50,000 by January 2006 and it is expected that all limits will disappear in due course. As intra-eurozone cross-border payments account for fewer than 3% of eurozone transactions many banks have decided to absorb the extra costs within a revised domestic pricing tariff. This is avoiding the issue and, when other single market initiatives become effective in promoting a greater degree of EU-wide supply chain sourcing, the position taken by these banks will become increasingly untenable.
Some of the main options are:
None of these options is simple and all will need massive investments. Also, the barriers to change are immense. There would be vested interests to assuage, both sectoral and national. More significantly, there is the issue of the Transfer of Undertakings and Protection of Employment (TUPE) legislation.
Suppose a leading bank decides to buy-out the transaction banking operations of, say, 11 other banks across the eurozone so that it now has domestic payments processing capabilities in all 12 member states. As clearing is an activity that is dominated by a classic economies-of-scale pattern of behaviour, the likely preferred strategy for the bank will be to consolidate its main operations onto a single site with a separate back-up operation. This will result in shutting down substantial operations in at least 10 of the countries now served by the bank.
The essence of TUPE legislation is that banks cannot offer to act as outsourcers to others without employing those people who will have been displaced by the outsourcing process, whether they are now needed or not. While this certainly protects employment, it also prevents productivity improvement and, ultimately, competitive consumer pricing. The biggest barrier to full SEPA implementation could well turn out to be TUPE legislation.
Many banks now find themselves with a series of seemingly intractable dilemmas. They do not have the scope of operations to offer eurozone-wide clearing services nor do they have the scale to justify the investment to expand. Also, while some of the larger players could offer outsourcing services as a way to build volume and extend reach, the TUPE legislation makes it an almost impossible option in cost terms if the client bank does not address its own redundancy issues. Many banks may well feel that their transactions clearing business is being condemned to a slow and painful death.
Banks are intermediaries in commercial relationships between clients. However, in the past 15 years banks have suffered from a significant degree of dis-intermediation in the payments processing cycle. Much of the payments process is about information management and many non-bank organisations have now become leaders in this field. Banks must, therefore, remember that only banks can pronounce finality of settlement (an essential component of commerce); that only banks are likely to provide the collateral for fair and efficient clearing systems (local, regional, and global); and that only banks may have the capability and the stature to certify payors and authorise payments. These are the cornerstones of any re-intermediation programmes to be adopted by the banking sector. Whether the payments franchise of the banks will thrive or move to non-bank providers is the key issue at stake.
The banking sector worldwide is becoming newly stratified as client needs are being better accommodated. Local banks still have strong appeal and in the age of relationship banking they now have new opportunities. Regional/multi-national commercial banks have emerged from the international expansion of leading national banks and they now provide services and a marketplace reach unattainable by local banks. To offer services to clients in a global market, the multi-nationals participate in a network of correspondent bank relationships. The leading correspondent banks have grown into the half dozen true global players and these global correspondent bankers are now evolving into bankers’ bankers.
These bankers’ bankers should have a natural commitment to investment in infrastructure and systems and this is the group to which politicians and businessmen must turn, to make a single payments area a reality in Europe. Only this group can mobilize the necessary reach and the scale to offer competitive one-stop-shop solutions; only this group can avoid conflicts-of-interest with its clients and its clients’ clients; but, in the EU, this group can only be effective for those banks that are willing to address directly the redundancy implications of outsourcing or white-labelling of payments processing.