Re-building a Healthy Financial System and Banking Industry

Published on 23rd June 2009

We all have lessons to learn from the past two years and of course new regulation will impact how we run our businesses; I welcome this as an important part of re-building a strong healthy financial system and banking industry. Lets start with first principles.

First, it’s clear that banks will be operating with more capital, with less leverage, and with higher liquidity, and in a regulatory environment that’s both more focussed and more globally coordinated. We’ll all have to manage and allocate capital more rigorously with a much greater focus on returns, not just growth corporate lending of course will continue, though it’s likely to be far more strategic and far more relationship driven there’ll be a premium on businesses that deploy capital on behalf of clients, rather than proprietary trading and activities which require excessive capital, risk weighted assets and leverage will adapt or disappear So for example, the warehousing of assets on the balance sheet over the long term is no longer viable that was clear immediately with sub-prime mortgage assets it’s becoming more clear with commercial real estate.

The originate and distribute model will adjust so banks absorb only those assets they can be sure of distributing and securitisation will certainly continue albeit in a simpler form. We’ll see less special purpose vehicles off balance sheet, large proprietary positions that consume capital but don’t advance client relationships will be much harder to justify, and every institution will make trade-offs between activities that consume high levels of capital and those that consume less preserving capital for relationships and activities that are strategically important, with a focus on maximising returns.

There’ll also be a much greater focus on liquidity and liquidity has a lot to do with brand, a lot to do with reputation and a lot to do with confidence but it also comes down to funding and risk management there’s no better way to diversify your funding and diversify your risks than the integrated universal banking model. Banks that are diversified by business, by client base and by geography will simply have a strong competitive advantage. There’ll be far greater transparency as well: whether its through disclosure on the levels of exposures, the structure of products, risk management processes, or compensation plans. Stress tests are also an important part of transparency and we support them: we think they’re a vital piece in the regulator’s toolkit and should be a regular part of the supervisory process And we also want to see new market developments New market developments such as centralised clearing and settlement mechanisms which are important to reduce operational and counterparty risk. So will the world look different in a year or two? Absolutely. There’ll be much greater focus on return on capital there’ll be much greater need to manage liquidity and there’ll be much more transparency for investors, for regulators and for market participants.

This should be a world which both the industry and investors find reassuring, because confidence is critical. Of course profitability is critical too, so let me talk more about that. In all periods of market dislocation, priorities change. The thing that strikes me most in this environment is that our clients need us more than our clients have ever needed us.

Put yourself in their position for a second: whether they’re corporates, financial institutions, or governments whether they’re hedge funds, pension funds or private equity firms, they’re all facing similar issues: it could be about accessing capital, about deleveraging, about increasing liquidity, about managing volatility, about restructuring the balance sheet, it could be about market consolidation Whereas in the past they had plenty of banks and non banks they could turn to and the financial markets were very liquid today there are fewer institutions that can help them. So the most important factor in selecting a bank today is the ability to create a deep relationship; that decision will be relationship led, not transaction and it will not be price led; and the concept of a strategic relationship has today become more important than ever.

In a world with more demands on capital, in a world with less leverage and tighter regulation, clients will develop fewer but deeper relationships and as a result, they’ll chose firms that can serve them globally across a full range of products. Let me give you some examples of how growth is being driven by the issues our clients face right now, beginning with re-equitisation. Businesses across the board have to reduce their leverage and increase their equity capital UK corporates have raised more than £36 billion of equity so far this year and as I said earlier, US equity issuance was higher than ever in the month of May at almost $50 billion.

We see this need continuing as clients have to refinance their debt and revise their capital structure It’s a very similar story with risk management: volatility has surged from the middle of 2007 onwards, look at intra day currency volatility this year is over 20% for example and that compares to a traditional level of 5 to 10% in other words industry volatility is running at more than double the historic norm Or take oil for example which was priced somewhere between $60 and $80 a barrel in 2006 shot up to $145 in the middle of 2008 collapsed to $40 at the beginning of 2009 today it’s trading at more than $70 a barrel. That level of volatility can have a devastating impact on corporate performance so the demand for strategic advice on risk management has never been greater whether it’s currency risk, duration risk, credit risk, or commodity risk clients are looking to us to provide strategic solutions they want us to help protect their balance sheet, their liquidity, their profitability, ultimately their share price, investors now scrutinise risk management as closely as financial performance.

Maybe one of the greatest areas of growth in the next couple of years is going to come from governments around the world governments who’ve increased their borrowing and government who have invested directly in private enterprises to mitigate the impact of the downturn This is creating opportunities, in the near term through distressed asset programs for example, and over the longer term through government debt issuance and the need to re-privatize government owned institutions In the US alone, the government will have to raise $2 trillion of new debt during the course of 2009. So clients have new and challenging priorities and there are fewer financial institutions well placed to respond.

Given this backdrop, what are the important attributes for success? First it won’t surprise you for me to say that, success will come down to client focus Remember – even before the turmoil at least three quarters of industry revenues were client driven. But it’s not just about placing the client at the heart of the business. It’s being able to provide them with strategic advice and strategic solutions and for that you need a full range of businesses that are truly integrated, there’s no place for product or geographic silos . To be a successful firm you also need scale and high quality execution. In a world where the leading players are growing their share of the market faster successful firms will be those with a global client franchise and a global technology and operating platform that can serve those clients. Third, financial discipline and a focus on returns; In a world where there’s a premium placed on capital and liquidity successful firms will be those who can allocate their capital and manage liquidity in such a way as to maximise returns. And in a world where risk management has never been more important, successful firms will be those with revenues that are well diversified by business, by geography and by client.

In other words, there’s a clear advantage for the integrated universal banks. We’ve been through a period of dramatic market dislocation which has been painful for all of us But the successful firms will be those who’ve emerged better positioned to serve client needs and better positioned to take advantage of the opportunities that I‘ve talked about to deliver sustainable shareholder returns.

By Robert E. Diamond Jr.

Robert E Diamond Jr. is President of Barclays PLC and Chief Executive of Investment Banking and Investment Management. Excerpts from his presentation during the Barclays Capital Investor Seminar  in New York.

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