How Banks Can Find Opportunity in a Flood of Regulations

Recent liquidity and capital rules designed to shore up banks' viability and solvency are just the latest efforts in a multiyear regulatory overhaul. This intensified oversight has undoubtedly increased banks' compliance costs and restricted certain activities. But regulatory reform should not be seen only as a hindrance. Indeed, it may well provide opportunities for banks to differentiate from one another as well as rebuild their reputations.

In September, the Federal Reserve and other banking agencies approved liquidity standards for large and internationally active U.S. banks, requiring them to hold minimum amounts of safe assets such as cash, high-quality corporate debt and government bonds that can quickly be converted to cash. Less stringent rules also apply to smaller financial institutions.

Building upon the Basel capital standards, the Fed also announced plans to levy capital surcharges on large banks, with progressively higher surcharges as their systemic importance increases.

Under the new regulatory scenario, banks will be required to have much more capital of the highest quality. Capital will be evaluated in terms other than solely risk-weighted assets, as these have proved to be highly subjective and not good predictors of bank difficulties. As a complement to risk-weighted capital, we expect new requirements regarding total assets (unweighted leverage ratio). This will have deep implications on banks’ business models.

Capital allocation to different business lines will have to be much stricter, and subsidies among lines will no longer be possible. Scarce capital will be allocated to those business lines able to generate appropriate return on equity, while many traditional lines will appear to be unprofitable and will be abandoned.

On the upside, better-capitalized banks should be perceived by markets and investors as less risky than in the past, and therefore required risk premiums should be lower. In short, banks will need more capital, but the cost of capital will come down once confidence is further restored.

Banks that have already invested in automated processes, digital capabilities and risk management have an opportunity to take advantage of the transition period for these rules before the market adjusts to a new low-risk environment. As long as stock market valuations are substantially better for banks that exhibit better management performance, these banks will be in a good position to issue shares and strengthen their capital base. This will put them ahead of the competition by the time the new requirements go into effect.

This transition will be easier for banks that are able to generate internal funds and persuade new and existing investors to buy stock. These banks may generate a return on equity in the range of 8-10%, as higher capital ratios should translate into lower perceived risk for bank equity. In addition to more stable capitalization, the search for higher ROE will largely depend on banks’ ability to reduce operating costs, improve revenue productivity and adopt a business model that can leverage the benefits of the digital era.

Large, complex banks will face an additional challenge, as they are required to cover additional capital surcharges as a result of the systemic risk they represent. While these requirements may seem onerous, they will ultimately better position large banks to attain higher ROE ratios.

Going forward, the new regulatory framework will necessitate renewed attention on profit and risk balancing across all lines of businesses. Banks will need to consider how to incorporate the cost of capital, liquidity and funding into their pricing.

Additionally, as customers demand increasingly complex and personalized services, banks must combine deep customer analytics with the ability to dynamically assemble the right products and services, leveraging third-party partners where appropriate. By fine-tuning the operating model and leveraging new technologies to move towards more real-time transaction processing, banks can improve control over costs and refocus efforts on managing customer relationships, risk, balance sheets and other critical challenges.

In short, banks must do business differently. Sweeping changes, from new regulations to technological advances, digitally sophisticated consumers, growing competition from non-traditional players and the rise of emerging markets, are reshaping the industry. The high performers will be those able to develop smart strategies to navigate through this sea change.

Juan Pedro Moreno is Accenture’s senior managing director of global banking and co-author of A New Era in Banking. Steve Culp is Accenture’s senior managing director of global finance and risk.