UK: THE BANKS FIND THEIR BALANCE. - The banks have abandoned their expansionist policies of the 1980s and are 'constructively shrinking'. Is this a fundamental change or just the next stage in the same old boom-and-bust banking cycle?

by Martin Vander Weyer.
Last Updated: 31 Aug 2010

The banks have abandoned their expansionist policies of the 1980s and are 'constructively shrinking'. Is this a fundamental change or just the next stage in the same old boom-and-bust banking cycle?

'I'm not worried whether the business is growing as fast as the capital base,' says Martin Taylor, chief executive of Barclays. 'If the capital base grows faster than the underlying business, we'll return some of the capital to the shareholders. I don't find that problematic. If you try to grow a business at a time when the market is trying to shrink, you just end up destroying capital.' The appointment of Taylor, the 42-year-old former chairman of Courtaulds Textiles and one-time Financial Times Lex columnist, was perhaps the most radical measure taken by any of Britain's high-street banks in the aftermath of a worldwide recession which called into question all the received wisdom of the financial world of the previous decade. The idea of constructive shrinkage - as expressed here by Taylor at Barclays and already partially put into practice by his opposite number, Sir Brian Pitman, at Lloyds Bank, where the balance sheet has shrunk by 30% - is a truly radical one, diametrically opposed to the expansionist machismo which led the mid-'80s generation of clearing bank bosses into such desperate difficulties. It is just one tenet of a creed of post-modern banking in which the driving force will be utility rather than ego: austerity, prudence and serious, long-term thinking have broken out all over the City.

In this unfamiliar new environment, stripped of their mahogany panelling and their liveried messengers, clearing bankers are grappling with two major challenges: to reduce their cost-base until it comes into equilibrium with the volumes and types of business they actually want, rather than piling on high-risk lending at fat margins in order to cover inflated overheads and fill vacant balance-sheet space; and to explore the limits of banking technology, to provide personal and corporate customers with electronic services which are user-friendly, cost-competitive and impeccably reliable.

But can the future really be different from the past? Or have we just reached a particular point in the same old boom-and-bust cycle - the first sign of an upswing - at which the bankers traditionally announce that they have rediscovered sound management and will never make all those dreadful mistakes again? Are any of their ideas so radical that the new men can hope to flatten the cycle beyond recognition?

Taylor certainly doesn't go that far. Rather, he sees it as his job to ride the next cycle more elegantly, by bringing more and more of the variables directly under management control: 'I don't object to cyclicality as such. It's a fact of life that banks produce volatile results over the course of the economic cycle. The fluctuations are generally not very large in relation to a balance sheet of over £170 billion. Bad debts of £1 billion per year are not out of order for a bank of this size. But the sort of volatility we've had recently goes beyond what's acceptable.' Veteran Lloyds chief Pitman leans further towards macroeconomic optimism: 'We now have as good a chance as I've seen for stable growth. We're looking at low inflation for a prolonged period of time. It's a new world for banks: we will not have the same levels of boom and bust.' A leading bank analyst, Richard Coleman of stock-brokers Smith New Court, offers an objective but mildly cynical comment on the same question: 'Banks are often better managed from adversity than from strength,' he observes. 'But we still believe in cycles, and we still think inflation is likely to bubble up again once the level of growth is back to the long-term trend line. In the banking cycle, there usually comes a point at which the management can no longer withstand the urge to do all the things they did last time round. Then there's a stage where they simply lose control of their own destiny.' Whoever is right, the most important key to steadier performance for the banks is in the area of lending - or not lending - to businesses. At Barclays, Taylor is in the process of 'purging the quality of the loan book', introducing new systems of credit control which prevent the build-up of excessive exposures to individual names and to high-risk business segments or geographical areas. 'You can only do this once you've taken the decision that you're prepared to get smaller in this area,' he says. 'You can't tell managers to improve the quality and to keep market share moving ahead at the same time.' One of the tools for this exercise is a new method of accounting for provisions against bad and doubtful debts. In the past, these have been recognised only as and when a loan begins to look as if it might never come back. Taylor is now introducing a system of running provisions, which recognises the level of risk inherent in a particular loan as soon as it is put on the bank's books.

This, he says, will make the pricing of loans more scientific, and will force managers to recognise the consequences of their own lending decisions, whereas the old system gave a distorted view of individual managers' profitability: every loan looked profitable until the moment (often long after the manager responsible had been promoted elsewhere) when it was suddenly recognised as an outright disaster. After adjusting the accounting basis to reflect the underlying risks, many loans turn out to be earning nothing whatsoever for the bank, 'So if we take them off the books, we make our shareholders richer. That's a wholly beneficial thing to have done.' But Taylor denies that he is taking discretion away from his managers: a computerised credit-assessment programme, called Lending Adviser, has been developed, but is carefully described as a 'decision-making support tool. My preference is to give the managers the maximum freedom within clear constraints. We should give people clear guidelines as to what lending and pricing is appropriate, and let them get on with it.' The same sort of policy - reinvigorating managers by giving them back responsibilities which had been taken away - was an overt feature of the recovery of Midland Bank under the leadership of Sir Brian Pearce in 1992-93.

These lending policies suggest, however, that it will become more difficult for companies to borrow - particularly for small businesses and new ventures. Taylor acknowledges that corporate lending has become generically less attractive: 'Cyclicality has been so over-whelming that we tend not to notice the structural downtrend, but the fact is that our best customers are borrowing less and less, so that the universe of lending opportunities is moving towards the riskier end of the spectrum.' For the time being, corporate loan demand is at a low ebb in all sectors. The absence of inflation, and a trend towards running manufacturing and retailing businesses on lower levels of stocks, has removed the two major factors for growth in working capital financing, while capital investment remains cautious and patchy. But even as economic conditions become gradually more favourable, those companies which are looking for financing in the next few years may find their bank managers taking an uncompromisingly tough line.

The same kind of minimalist thinking is being applied to the banks' overseas networks. Once upon a time it was received wisdom that a big bank had to be big in every important market in the world. In the late 1970s and mid-1980s, the British banks pinned their little flags all over the globe, whether in branch networks or in local joint ventures. Much of that expansion has now been recognised as folly.

Lloyds was the first to declare that it would 'rather be a leader in a few markets than a minor participant in many,' as Pitman says, and only in New Zealand does it now have a substantial branch network which resembles its home format. At Barclays, Taylor rejects the idea 'that we can go and replicate ourselves all over the world. That just creates huge over-capacity. The only way to do it is to buy other banks, and the only banks which regulators are happy to see sold to foreigners are usually sick ones. The problem is whether you can bring something new to an overseas market, in order to build up a customer base. If you can't, then you either compete on price, or you end up taking the business no-one else wants. We've tried both methods, and neither of them works.' The alternative, he says, is to 'go with the grain of the customers' business', cutting back both the aspirations and the cost-base to the bare essentials necessary to service those customers the bank actually wants, often concentrating on cross-border services and making use of reciprocal arrangements with local banks. In North America, Barclays has scaled back dramatically, and no longer sees the possibility of becoming a domestic player - in contrast to National Westminster and Hongkong and Shanghai Banking Corporation (HSBC ) - parent of Midland Bank, and owner of the otherwise unrelated Marine Midland Bank in the US, both still wrestling with medium-sized commercial banking businesses there which never quite seem to achieve critical mass.

Slimmed-down overseas networks, reluctant to lend but keen to service an international client base, create a requirement for increasingly sophisticated operational technology. Here the market leader is probably HSBC/ Midland, with its Hexagon service. Developed in Hong Kong and now available in 35 countries, Hexagon equips 45,000 corporate customers with terminals through which they can make international payments, transact foreign exchange deals and arrange basic forms of trade finance. Global securities handling for investment institutions is another area of fierce competition based on quality of systems and service.

International commercial banking is, then, set to become a skeletal remnant of what the big players once thought it was possible to be: highly selective in risk, product range and location. But investment banking - including money market and securities trading, corporate advisory work and asset management - is still seen as a potential growth area by those banks which have achieved a significant presence - principally Barclays and the HSBC Group (incorporating Midland Global Markets and James Capel), with NatWest a poor third.

BZW, Barclays' investment banking arm, produced bumper profits boosted by exceptional results in foreign exchange trading, at the low point of the commercial bank's troubles in 1993. Trading and fee earnings are by nature volatile, Taylor says, but provide a satisfactory portfolio effect. 'We'd like the securities business to be a lot bigger, commensurate with profitability and risk. We have very stringent risk management in that area now, and in any event the risk components - like exposures to derivatives markets, which everyone tends to worry about - don't all go the same way; there's a huge netting effect. And some parts of it, like asset management, are very stable indeed. In its present form, Barclays can amply supply BZW with the capital it needs. The constraints on growth in that area are human and managerial rather than financial.' A strong capability in asset management has implications also for retail banking. One of the most fundamental changes predicted in personal finance for the next generation is a shift in emphasis from borrowing to saving. The harsh experience of the past five years has made many people reluctant to borrow beyond an essential first mortgage, and has caused them to distrust the idea that their personal wealth will gradually increase through the rising value of equity in their houses.

Accumulation of financial assets, including PEPs, unit trusts, personal pensions and healthcare schemes, will become much more commonplace, as in the US. At the same time, an extended period of low inflation and relatively low interest rates will make simple bank deposits less attractive as a form of saving. The banks have the opportunity to become the channel through which individuals build up and manage increasingly complex savings portfolios, but they need some powerful new ideas to help them do so.

Acquisitions in the retail fund management field are one possible route, but Lloyds' £1.8 billion takeover of the Cheltenham and Gloucester Building Society is another indication of the way the market may develop. Building societies are highly efficient mechanisms for attracting savings, their basic mortgage business is now once again in the category of low-risk lending, and the economies of scale in such mergers, in terms of potential branch closures, are obvious. Within the banks themselves, the ingenuity which in recent years has been applied to designing consumer loan packages and securities products will increasingly be applied to creating savings products to be sold to individuals through the branch network and, perhaps most importantly, down the telephone. Technology, particularly in the form of telephone banking, is the crucial issue for the future of retail banking, whether in terms of reducing the cost-base, of maximising the spin-off value of each current account held, and at the same time of recovering the approval of small business and personal customers. 'Most people take banks for granted,' says Taylor, 'and in a sense that's the way it ought to be. But we have not been good as an industry at the more positive features of customer service.

Some very rough justice was meted out to customers during the recession - particularly to small businessmen - and the idea has lodged in the popular mind that banks are inconsiderate, brutal, greedy and incompetent.' Although the banks are anxious to deny it, many customers have found the day-to-day experience of dealing with their bank deteriorating rather than improving in recent years, as branches are de-staffed and decision-making powers drawn back into regional centres. Meanwhile, mass customer businesses such as British Telecom, and even government entities like the Inland Revenue, have developed telephone query-handling services which make them incomparably more efficient in their direct dealings with the public, putting the banks to shame. Younger generation customers regard telephone or plastic card transactions as natural, placing a high priority on the ability to obtain an instant answer to their needs or queries.

The one completely successful answer to this challenge so far is First Direct, the Midland Bank's telephone banking subsidiary, offering a full range of customer services 24 hours a day from a single site in Leeds. Now five years old, First Direct has 450,000 customers (only 23% of whom came from the Midland) and expects to have 1.2 million by the end of the century, by which time at least 20% of all UK banking will be done by telephone. First Direct's own customer surveys claim that 86% of their customers are very satisfied with the service they receive, compared with a dismal 43% for high-street bank users.

All the banks recognise how much ground they have to make up in this respect, and that huge investment will be required. Most have declared their aim to develop an integral telephone service, in which all existing customers can access their accounts more effectively, without the need to transfer their business to a new vehicle like First Direct. NatWest has introduced 24-hour telephone banking for 360,000 customers in the Thames Valley region. Barclays has committed £2.6 billion and is experimenting with its Barclaycall service in 30 areas: the Royal Bank of Scotland and the Trustee Savings Bank also claim innovative schemes.

Telephone banking, new generations of electronic cash machines and the possibility of further bank/building society mergers all point inexorably towards more branch closures and job losses in the banking industry. Personal customers might quite rapidly adjust to the idea of not being a customer of a specific branch at all; only small business customers still require a high degree of face-to-face contact at the local level. Some sources suggest that if existing technology were to be developed to its logical limits in the big banks it would allow a reduction of staff numbers from their present level by as much as 50%.

But for the banks themselves, these potential efficiency gains are not an entirely unmixed blessing. The costs of a branch network also represent the chief barrier to entry for foreign or non-bank competitors: the greater the commoditisation of banking products, and the propensity of customers to shop around for better value, the more open the market is to competition. Already the banks are looking rather nervously at the likes of General Motors, which now issues credit cards with usage linked to discounts on car prices. Pitman points to the example of the telephone giant, AT and T, in the US, also now in the credit card business with the advantage of a huge existing customer base and direct knowledge of how good each one is as a payer of bills.

Increased competition and consumer awareness will mean pressure on bank charges, reinforced by political hostility towards the banks from the likes of Gordon Brown, who may well be Chancellor of the Exchequer in a couple of years' time. Even the prospect of improved dividend returns, if the idea of giving surplus capital back to the shareholders is put into practice, is not without its delicate political implications: increased returns to shareholders may begin to exceed the interest rates offered to small depositors, and may look controversial in an era of almost-zero annual pay awards for staff and continuing job losses. Bank profits will inevitably come under attack again at some stage and (proving, indeed, that cycles still exist) there will be more rounds of criticism of the banks for their low-risk thresholds in lending to small businesses and new ventures.

Even with the wisdom of hindsight, the benefits of advanced technology, the comfort of capital ratios going through the roof and the freedom, as Barclays' Taylor puts it, 'to shoot all the sacred cows', it will not be an easy ride for the management of the high-street banks over the next few years. It should, however, be a period in which personal and business customers see a genuine improvement in standards of service from their banks.

As Pitman says: 'This used to be a seller's market - you were doing people a favour offering them a loan. Now, if you don't work out exactly how and when they want the product delivered, you'll miss the opportunity to sell it to them. In a low-inflation environment, customers feel poorer and are more prepared to shop around and bargain. They want better value for money and they want product innovations designed to fit very specific needs, yet they also want a minimum amount of disturbance. They want convenience, efficiency, quick answers and total confidence in the system.' From the customer's point of view it should all be a great improvement: the only thing that will be more difficult than ever will be borrowing money.

Martin Vander Weyer is an associate editor of The Spectator.

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