Financial Service UK Banks Performance Benchmarking Report HY Results 2011

FINANCIAL SERVICES

UK Banks: Performance

Benchmarking Report

Half Year Results 2011

kpmg.co.uk

c UK Banks: Performance Benchmarking Report | Half Year Results 2011

Basis of Preparation This report summarises the 2011 interim results of Barclays, HSBC, Lloyds Banking Group (‘Lloyds’), Royal Bank of Scotland (‘RBS’) and Standard Chartered1.

Information has been obtained solely from published interim and year end reports (including analyst packs from results presentations).

Where total numbers are presented it is the total of the five banks in the review. As an example, total assets is the sum of the total assets of the five banks, expressed in sterling. Similarly, if an average number is presented, it is the average of the five banks in the review. We have used simple headline numbers in our analysis unless stated otherwise; each bank has its own way of reporting performance and this has proved to be the most consistent method of presenting their results.

HSBC and Standard Chartered present their results in dollars. These have been translated into sterling using the relevant period end or period average rate. Where percentage changes are presented for HSBC or Standard Chartered, these percentages are based on the dollar amounts disclosed by the banks, rather than on the sterling translation of those amounts.

Note that any discussion of ’underlying’ results (or, in the case of Lloyds, of ‘combined business basis’) reflects a number of adjustments to statutory figures, as determined by management. Underlying results will therefore not be comparable from bank to bank. Management reporting in the bank results focuses on underlying figures.

Adjustments commonly include:

• elimination of currency translation gains and losses

• elimination of goodwill, profits and losses on acquisitions and disposals of subsidiaries and businesses

• exclusion of liability management gains or fair value changes on own debt

• inclusion of shares of profits of associates and jointly controlled entities within underlying non-interest income

• exclusion of certain write-downs and one-off items.

The ‘UK retail banking’ section also includes the results of Clydesdale Bank, Nationwide Building Society and Santander.

© 2011 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

1

Contents

1. At a glance 1

2. Summary 2

3. Profitability 4 Overview of financial performance trends UK retail banking Investment banking Cutting costs gains new urgency

4. Asset quality 23 Impairment Balance sheet Non-core loan sales emerge

5. Regulatory and accounting change 35 Capital adequacy Where to draw the line around ICB proposals? CRD 4: Basel 3 with a twist IFRS brings wave of change

6. Banking innovation and the future 49 Investing in innovation Economic update Outlook

© 20© 20111 KPMG LLP1 KPMG LLP, a UK limited liabilit, a UK limited liability partnership, is a subsidiary partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG y of KPMG Europe LLP and a member firm of the KPMG

netnetwwork of independent member firms afork of independent member firms affiliated with KPMG International Cooperativfiliated with KPMG International Cooperative, a Se, a Swiss entitwiss entityy. . All rights reserAll rights reservved. ed.

1 UK Banks: Performance Benchmarking Report | Half Year Results 2011

1. At a glance2

Barclays RBS Lloyds HSBC3 Std. Chtrd.3

2010 2011 2010 2011 2010 2011 2010 2011 2010 2011

Ranking

By PBT 2 2 5 4 4 5 1 1 3 3

By total assets 2 2 3 3 4 4 1 1 5 5

By net assets 3 3 2 2 4 4 1 1 5 5

Statutory profit before tax (£ billion)

Net interest margin (basis points)4

Cost to income ratio5

3.9

198

58.6%

2.6

197

70.6%

1.2

199

58.0%

(0.8)

200

57.0%

1.3

208

43.5%

(3.3)

207

52.4%

7.3

278

50.9%

7.1

254

57.5%

2.0

230

54.3%

2.3

230

54.0%

Impairment charge (£ billion)

Return on Equity6

3.1

9.8%

1.8

5.9%

5.2

14.3%

5.1

13.4%

5.4

-

4.5

-

4.9

10.4%

3.3

12.3%

0.29

14.7%

0.26

13.0%

Impaired loans to loans and advances to customers

Impairment cover

5.5%

51.0%

5.2%

49.2%

7.3%

46.8%

8.3%

48.7%

10.3%

45.9%

10.6%

45.2%

2.9%

72.1%

2.5%

72.7%

1.7%

62.5%

1.6%

61.2%

Total assets (£ billion)

Net assets (£ billion)

Core Tier 1 ratio

1,490

62.3

10.8%

1,493

62.0

11.0%

1,454

76.9

10.7%

1,446

76.2

11.1%

992

46.9

10.2%

979

45.5

10.1%

1,583

99.9

10.5%

1,682

104.7

10.8%

334

25.1

11.8%

354

25.9

11.9%

2. All numbers that relate to the income statement are for the six months ending on 30 June of the year and the balance sheet numbers are as at 30 June 2011 and 31 December 2010 respectively.

3. HSBC and Standard Chartered’s numbers are presented in US dollars, converted to sterling so as to present the data in the same currency. The exchange rates used were obtained from www.oanda.com

4. Barclays did not present net interest margin information on a consolidated level as did the other banks in the report.

5. Cost to income ratios are the published headline figures reported in the financial statements which, except for Lloyds, include PPI remediation costs.

6. Lloyds did not report return on equity. © 2011 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

UK Banks: Performance Benchmarking Report | Half Year Results 2011 2

2. Summary

Bill Michael, UK Head of Financial Services

Combined interim profits of the five major UK banks were nearly half those recorded in June 2010 due to the impact of remediation costs of Payment Protection Insurance (PPI), sovereign debt losses and continued lacklustre income growth. Some good news is to be found in the impairments line, where losses on corporate and consumer loans remained at relatively low levels due largely to a favourable interest rate environment and stable levels of unemployment.

However, with most Western economies in a fragile state and significant regulatory headwinds there are unsurprisingly some concerns as to where profit growth will come from in the future.

Profitability Continued reductions in impairment charges (a total £4 billion reduction compared to June 2010) are by far the biggest single positive contributor to profit performance of the five major UK banks, thanks largely to more stable economic conditions in the UK and US.

However, when the cost of dealing with PPI remediation (£5.4 billion) and Greek sovereign debt impairment (£0.8 billion), are layered on top of the existing revenue and cost challenges, a 50 percent reduction in half year profits is inevitable. Only HSBC and Standard Chartered achieved an increase in profits, reflecting their lower exposure to the UK market.

A natural reaction to an increase in market-wide events hitting bank profitability is a focus on controllable costs – in the period we have seen the announcement of over £5 billion per annum in targeted cost cutting by 2014, as lowering costs gains a new sense of urgency.

Asset quality The total assets of the five major banks remained broadly stable at £6 trillion in aggregate, however, the composition continues to shift as run-off non-core portfolios in Lloyds and RBS make way for new assets in Asia Pacific, originated by HSBC and Standard Chartered.

As noted above, the first half of 2011 has been a relatively quiet period for impairment losses, with most banks benefiting from customers continuing to deleverage their personal and corporate balance sheets. However, the big question remains, will this continued deleveraging sufficiently reduce the risk in bank portfolios in time for a possible rise in interest rates? Perhaps the only good news from the last few weeks of turmoil in the markets is that interest rates are more likely to remain low for longer. Many sectors of the UK economy remain fragile, particularly retail and real estate, and could give rise to impairment losses in the second half.

Recognising these potential future risks and with new buyers entering the market, we are seeing that non-core loan sales are increasingly on the agenda for many financial institutions.


New regulations will drive further major changes to banking business models already buffeted by political challenge and a volatile economic climate


“

”

Regulatory and accounting change The regulatory and accounting change agenda was already moving fairly fast but seems to have gained another kick of pace in the first half of 2011. The Chancellor’s public endorsement of the Independent Commission on Banking’s proposals in June suggests that ring-fencing of UK retail banking activities is now a likely outcome and, together with the latest version of the Capital Requirements Directive (CRD 4, based on Basel 3), will have a profound impact on banking business models which have already been buffeted by regulation, political challenge and a volatile economic climate.

Successfully balancing regulatory change, political pressures and shareholder objectives is becoming increasingly challenging and requires a comprehensive and coherent view of the organisation, and the multiple – and possibly overlapping – impacts of the wide ranging regulatory agenda. Banks must take a holistic view and adopt a coordinated approach to avoid the risk of unforeseen strategic and operational impacts, non compliance, and in particular the increased time and cost of duplicated or conflicting implementation efforts.

A wave of new accounting standards precipitated by the reaction to the financial crisis also took shape in the period. Many argue that these standards will have a more significant impact than the initial implementation of International Financial Reporting Standards in 2005, and will fundamentally re-write banks’ balance sheets.

Banking innovation and the future The banking playing field is being fundamentally redrawn as economic power shifts from West to East; regulators demand a much safer banking system and the accountants design a new way of keeping score.

In these times of uncertainty, the natural reaction may be to hunker down and wait for conditions to improve. However, with developments in technology and customer behaviour it is important to take a serious look at a number of innovations – mobile services, social media and personal financial management – as critical weapons in the fight for customer profitability.




3. Profitability

Nigel Harman, UK Head of Banking

In this section of the report, we explore the reasons for the 50 percent reduction in the aggregate profitability of the five major UK banks; considering the numerous one-off items that have impacted on the results during this period together with the longer term lack of revenue growth.

Specifically, we focus on the challenges of the continuing low interest rate environment for retail banks and the sluggish second quarter trading volumes for investment banks – both are resulting in real problems growing top-line revenue.

These top-line issues have led to a new urgency in cost control and we have seen a number of announcements from banks about their cost reduction strategies over the next few years – in total over £5 billion per annum in targeted cost savings to be realised by 2014.

In this chapter Overview of financial performance trends 5

UK retail banking 9

Investment banking 13

Cutting costs gains new urgency 19


Overview of financial performance trends

As the economic environment remains unstable and the outlook uncertain, the first half of 2011 saw the five major banks make a combined statutory profit before tax of £7.9 billion, an increase on the preceding six months (£6.4 billion) but significantly down on the first half of 2010 (£15.7 billion). What are the drivers of this performance?

There were a number of key trends in the banks’ half year results:

• Profits were hit by large one-off items – predominantly provisions for Payment Protection Insurance (PPI) claims and, for RBS, Greek impairments

• Less favourable investment banking conditions reduced income while top line growth in all areas continues to be a challenge. Net interest margins generally fell from December 2010 due to challenging market conditions

• Significant reductions in impairment continue to be reported although some areas (particularly the Irish real estate market) remain a cause for concern

• HSBC and Standard Chartered continue to benefit from geographic diversification, with the Asian markets being a key contributor to profits.

Exceptional items and one-off adjustments The banks’ statutory results all include a number of non-recurring one-off items which arose due to stand alone transactions outside of the core business or accounting adjustments that have a significant impact on the profits reported. Each of the banks makes adjustments to its own underlying profit measure; however, it can be challenging to achieve a consistent measure for comparison purposes.

The following table adjusts the statutory profit or loss for these items to derive a theoretical ’core’ profit measure.




Barclays RBS Lloyds HSBC Std. Chtrd.

£ billion H1 H2 H1 H1 H2 H1 H1 H2 H1 H1 H2 H1 H1 H2 H1 2010 2010 2011 2010 2010 2011 2010 2010 2011 2010 2010 2011 2010 2010 2011

Statutory profit/(loss) before tax on continuing operations 3.9 2.1 2.6 1.2 (1.6) (0.8) 1.3 (1.0) (3.3) 7.3 5.0 7.1 2.0 1.9 2.3

Payment protection insurance provision 1.0 0.9 3.2 0.3

Greek sovereign debt impairment 0.7 0.1

Integration and restructuring costs 0.1 0.4 0.6 0.4 0.8 0.8 0.6 0.1 0.3

(Gain)/loss on revaluation on own debt

(0.9) 0.5 (0.1) (0.5) 0.3 0.1 (0.7) 0.7 0.1

Change in value of APS fair value swap 1.6 0.6

Change in fair value of equity conversion feature of Enhanced Capital Notes

(0.2) 0.8 0.2

Profit on debt buy back and extinguishments

(0.6) (0.3) (0.4)

(Gain)/loss on sale or acquisition of businesses

(0.1) (0.1) 0.1 0.4 (0.5) 0.4 (0.2) (0.2) (0.1)

Customer goodwill payments provision 0.5

Changes to pension schemes (0.2) (1.0) 0.1 (0.1) (0.4)

Charge/(credit) related to insurance volatility

0.2 (0.5) 0.2

Core profit/(loss) before tax 2.7 2.5 3.7 0.9 0.4 1.6 0.7 1.1 0.9 6.3 5.6 7.4 2.0 1.9 2.3

For all of the banks (except Standard Chartered) the impact of eliminating the impact of one-off items is to increase profitability for the six months to June 2011. Standard Chartered has not experienced significant one-off gains or losses in the period and core profit is equal to statutory profit.

The principal reason for this trend is PPI claims for which a total of £5.4 billion has been set aside by Lloyds (£3.2 billion), Barclays (£1 billion), RBS (£0.9 billion) and HSBC (£0.3 billion).

RBS also reported a £0.7 billion impairment of Greek sovereign debt. The other banks either had very small comparable impairments or did not specifically report the impact.

Other significant one-off items which have reduced statutory profit in the period include fair value changes in Asset Protection Scheme swaps (RBS) and the continued spend on integration and restructuring at Lloyds and RBS.

HSBC and Standard Chartered continue to benefit from their geographical diversification and lower dependence on the fragile European and North American markets. Standard Chartered reported a record first half profit for the ninth straight year with increased income in all regions except India. HSBC reported a profit in all geographic regions and double-digit growth in Asia, Latin America and North America. It is striking to note that Asia Pacific now contributes 59.5 percent of HSBC’s statutory profits.


Profits at HSBC, RBS and Barclays were significantly impacted by falls in income in their investment banking businesses as the buoyant market conditions experienced in the first half of 2010 were replaced by a lower risk appetite driven by concerns about the Eurozone.

Statutory profit/loss before tax (billion GBP)

8.0

7.0

6.0

5.0

4.0

3.0

2.0

1.0

0

-1.0

-2.0

-3.0

-4.0

-5.0

A B C D E A B C D E A B C D E A B C D E A B C D E


A: H1 2009 B: H2 2009 C: H1 2010 D: H2 2010 E: H1 2011

Source: KPMG LLP (UK) 2011

Net interest margin Net interest margins remained under pressure with a reversal of the increases experienced from the first half to the second half of 2010. This was due to competitive deposit markets driving rates up, higher funding costs, repositioning of lending books and replacement of government debt with more expensive wholesale funding.

Standard Chartered was the only bank to increase net interest margin, to 230 bps compared to 210 bps in the second half of 2010, while Barclays, Lloyds and HSBC all experienced a decline. The biggest fall was at Barclays who reported a reduction of 11 bps to 197 bps driven by Barclays Corporate and Barclaycard.

Lloyds and RBS both reported lower income levels due to ongoing asset reduction programmes. RBS did not report the margin for the second half of 2010.



“ Despite a clear reduction in the first half, it is quite possible that impairment levels are not out of the woods yet ”

Operating expenses The story on costs differed greatly at headline and underlying levels. Headline cost numbers increased significantly due to PPI provisions but, on an underlying basis, the stories were mixed.

HSBC and Standard Chartered both reported increased operating expenses as they continue to invest in expansion. Barclays reported a small (1.1 percent) increase due largely to restructuring costs, while operating expenses at Lloyds and RBS fell due to the benefits of integration and restructuring savings.

Impairment provisions Impairment charges continued to fall, with the total charge across the five banks in our report falling by 21.1 percent to £14.9 billion compared to the first half of 2010. The biggest reductions were at Barclays (40.6 percent) and HSBC (30.0 percent).

The trend was generally consistent across retail and wholesale/commercial books although some areas remain a cause for concern – notably the commercial real estate market in Ireland where Lloyds and RBS both reported increased impairment levels. Lloyds also experienced an increase in impairments in its Australasian book.

The reduction in impairments has been driven by a low interest rate environment and consumer desire to reduce unsecured debt levels. With the economic outlook still uncertain, particularly with government austerity measures, potential interest rate rises and the current Eurozone crisis, it is quite possible that the banks’ impairment levels are not out of the woods yet.



UK retail banking

The most recent results of the major participants7 in the UK retail banking market illustrate the increasing challenges of operating in a low interest rate economic environment. Additionally the costs associated with the burden of regulation are becoming increasingly apparent.

Some of the notable themes emerging in the first half were:

• Significant one-off costs for anticipated customer redress associated with past sales of Payment Protection Insurance (PPI)

• Mixed impact of margin compression resulting from retail and wholesale funding rates

• Further decline in overall impairment charges as customers continue to pay-off debts.

Defining UK retail banking Retail banking activities are defined differently by the various entities concerned, complicating attempts at direct comparisons between the businesses. However, when referring to UK retail banking we use the following classifications for the purpose of our analysis7:

• Barclays: UK Retail and Business Banking

• RBS: UK Retail

• Lloyds: Retail

• HSBC: UK Retail Banking (HSBC Bank)

• Nationwide Building Society (‘Nationwide’): Full results8

• Clydesdale Bank (‘Clydesdale’): Retail9

• Santander: Santander United Kingdom10

Overall trends The first half statutory results have been dominated by the scale of the charges taken for provisions to compensate customers for the potential mis-selling of PPI and other redress programmes – Barclays £1 billion; HSBC £332 million (including other customer redress provisions); RBS £850 million; Lloyds £3.2 billion; Clydesdale £116 million and Santander £538 million (post tax). Only Nationwide bucks the trend with a relatively modest charge of £13 million. Our analysis of performance excludes the one-off distortions caused by the magnitude of these charges.


7. Standard Chartered does not have significant UK presence and is therefore excluded from the analysis.

8. Annual results for the year to 4 April 2011. Where applicable, income statement analysis reflects the six months ended 4 April 2011.

9. Interim results for the six months ended 31 March 2011.

10. Santander UK plc results presentation for the six months ended 30 June 2011.


UK retail banking performance – segment profit before tax excluding PPI provisions (billion GBP)

2.5

2.0

1.5

1.0

0.5

0 A B C D E A B C D E A B C D E A B C D E A B C D E A B C D E A B C D E

Barclays RBS Lloyds HSBC Nationwide Clydesdale11 Santander

A: H1 2009 B: H2 2009 C: H1 2010 D: H2 2010 E: H1 2011


Excluding the impact of PPI, underlying results show a degree of divergence in performance with the two principal drivers continuing to be interest income and impairment charges, as shown in the graph below.

Profit impact of impairment and net interest income movements (billion GBP)

0.6

0.4

0.2

0

-0.2

Impairment decline

Net interest income movement

-0.4

-0.6 Barclays RBS Lloyds HSBC Nationwide Clydesdale Santander


Where compression in interest margins has occurred it is principally driven by the increasingly competitive nature of the retail deposit marketplace as the banks seek to reduce reliance on wholesale funding. The pressure to increase liability margins can be a necessity to preserve existing retail funding. The growth in retail funds across the sector has been muted. The majority of customer deposit balances remained broadly flat across the period. It is only Lloyds that has experienced significant customer deposit growth of £6.7 billion (2.8 percent) to £242.3 billion. This increase has been driven by a particularly strong ISA season and Lloyds’ efforts to reduce reliance on wholesale funding.


11. Segmental disclosures for 2009 were prepared on a different basis so have been excluded from the analysis.

An increase in secured impairment charges has been mitigated by the low interest rate environment


Asset mix continues to be a key driver of impairment charges. The reduction in

“”

unsecured portfolios, as people reduce their personal indebtedness in the low interest rate environment, has driven the favourable movement in unsecured impairment charges experienced in the period. The worsening house price outlook has resulted in increased secured impairment charges across the sector. This increase has been mitigated by the low interest rate environment, which has seen secured arrears levels remain stable.

Impact on individual retail banks Lloyds continues to be the largest of the retail banks in terms of absolute profit for the period (£2.2 billion on a combined business basis), however it has also witnessed the biggest reduction in profits (11.8 percent) compared to the first half of 2010. Net interest income reduced 10.2 percent (£473 million), a reflection of the 18 bps reduction in net interest margin. The main driver of this reduction was the increase in wholesale funding costs, combined with the increase in the average rate paid on customer deposits, as Lloyds’ reliance on wholesale funding continues to reduce. Lloyds did benefit from a lower impairment charge in the period with a reduction of £162 million (12.1 percent) on the first half of 2010. Underlying the net impairment reduction, which was driven by a £404 million decline in the unsecured charge, was an increase in the secured impairment charge to £295 million from £53 million in the first half of 2010. This increase reflects the less favourable outlook for house prices compared with the outlook at June 2010. Fair value unwinds continued to boost Lloyds’ statutory profits with a contribution of £544 million (2010 £583 million).

RBS has seen the biggest rebound in earnings, an increase of £615 million (147.8 percent) on the first half of 2010. Net interest income was 11.8 percent higher, with net interest margin increasing by 22 bps. This was driven by stronger asset margins across all products tempered by a reduction in liability margins given the competition for retail funds-customer deposits remained broadly flat at £95.9 billion (31 December 2010 £96.1 billion). Impairment losses fell 41.5 percent (£285 million) in the first half of 2011. A significant reduction in the unsecured impairment charge (51.9 percent) to £286 million, offset by only a relatively small increase in the secured impairment charge of £24 million to £116 million in the period. RBS also benefitted from a reduction in direct costs as a result of operational efficiencies. Operating costs decreased by 7.1 percent to £1.4 billion with the cost to income ratio showing significant improvement to 49 percent (2010 57 percent).

The reduction in the loan impairment charge of £212 million (34.4 percent) contributed to the increase in the earnings in the period at HSBC. Like the other banks in the sector, a key driver of the reduction in the impairment charge is from the unsecured book as balances reduce and the mix of new business is weighted towards secured lending (mortgages). The results for the period were also impacted by an accounting gain of £292 million relating to the legislative change in the indexation of certain pension liabilities, which offset the provision for PPI and other redress programmes.

Barclays has seen a growth in earnings to £704 million (74.3 percent) with the increase again driven by interest margins and impairment reductions. A 7 bps increase in net interest margin to 146 bps has contributed to a £132 million increase in net interest income in the period, although there has been a 4 bps



decline from the second half margin of 150 bps. Impairment charges showed a decline of 38.5 percent to £275 million reflecting a reduction in personal and business impairment charges offset by a modest £7 million increase in secured impairment.

Nationwide results saw a continuation of this theme with underlying profit before tax for the six months to 4 April 2011 increasing by 35.8 percent to £129 million. The impairment charge was £180 million, a decline of £52 million (22.4 percent). This was driven by a reduction in impairment charges for both commercial lending and consumer finance, partly offset by an increased specialist lending charge. Net interest income at £779 million was £44 million lower as the interest margin declined by 2 bps stabilising at 81 bps, as retail asset re-pricing exceeded the cost of retail liability re-pricing.

Clydesdale had a 13.1 percent increase in retail earnings to £198 million for the six months to 31 March 2011. The main driver of this was a 34.5 percent decline in impairment losses. This reflects a change in the lending mix with a reduction in the unsecured lending book, growth in the secured portfolio, as well as overall arrears improvements reflected in a reduction of the number of loans which are past due. The interest margin declined by 2 bps as lower deposit margins were partially offset by higher lending margins from re-pricing activity.

Santander experienced a small decline in period on period earnings (3.2 percent) to £1.15 billion. This was driven by a 10.2 percent decline in net interest income to £1.85 billion, reflecting a reduction in margin of 21 bps to 186 bps. Wider loan spreads continue to be offset by higher liquidity and funding costs. The reduction in net interest income was offset by a significant decline in impairment (49.0 percent) to £235 million.

Growth in secured lending All seven banks have focused on gross secured lending and associated market share relative to book size. However, the net lending position is not always as clear. HSBC has experienced the biggest relative net increase in secured balances (5 percent) to £68 billion in the period. Lloyds on the other hand experienced a £4.2 billion decline in secured balances to £333.1 billion.

Impact of regulation The next 12 months will be a critical time for the UK retail banking marketplace. The macroeconomic conditions of historic low base rates, inflationary pressures and subdued housing market activity present a real challenge for banks to grow the top line. The new liquidity regime continues to place additional pressure on margins as the cost of regulatory liquidity increases. This is dampening the impact of increased margins on retail asset re-pricing activity across the sector.

The retail banking competitive landscape is poised to change considerably in the next 12 months. With the EU mandated retail business disposal from Lloyds (Project Verde), a buyer is expected to be identified by the end of 2011. In addition the ‘Good Bank’ of Northern Rock is expected to be returned to the private sector. Finally the Independent Commission on Banking is expected to issue its final findings in September, including recommendations on structural measures to reform the UK banking system and promote competition, as discussed elsewhere in this report.



Investment banking

For most investment banks on both sides of the Atlantic the first half of 2011 has turned out to be a disappointment. Early indications suggested that 2011 results would be either at par or better than 2010, with January and February enjoying robust trading volumes. However, from March onwards the situation deteriorated, with most banks seeing a slump in activity in the second quarter as stalling economic growth and deepening fears over the Eurozone sovereign debt crisis created a pervasive air of uncertainty.

Defining investment banking Investment banking activities are defined differently by the various entities concerned, complicating attempts at direct comparisons between the businesses. However, when referring to investment banking we use the following classifications for the purpose of our analysis:

• Barclays: Barclays Capital results, excluding fair value gains/losses on account of own credit spreads

• RBS: Global Banking and Markets (excluding Portfolio Management and the impairment charge relating to the loan books)

• Lloyds: the ‘Treasury and Trading’ business line within Wholesale

• HSBC: Global Markets, Balance Sheet Management (BSM) and Principal Investments

• Standard Chartered: the ‘Global Markets’ business line within the Wholesale bank.

The commentary in relation to expenses and cost to income ratio is at a divisional level at each bank, as it is not possible to analyse expenses on a basis consistent with the definition above.

Investment banking revenues are defined as ‘operating income’ for HSBC and Standard Chartered, and ‘income’ for Barclays, RBS and Lloyds.

Sovereign debt exposure refers to exposures to governments and central banks of a country along with quasi-government agencies.

Deteriorating performance As the chart shows, bank revenues have fallen from the previous period due to a combination of downside risks, in particular the Eurozone debt crisis and depressed trading volumes. The notable exception is Standard Chartered, which continues to benefit from its focus on emerging markets.



Total investment banking income (billion GBP)

8.0

6.0

4.0

2.0

0 A B A B A B A B A B


A: H1 2010 B: H1 2011


Barclays Barclays Capital continues to account for the lion’s share of Barclays’ results. Total income at Barclays Capital excluding own credit fell from £7.1 billion to £6.3 billion, mainly as a result of lower contributions from fixed income rates and credit, and commodities. However, currencies, equities and Prime Services income increased, in particular thanks to growth in derivatives and equity financing. Net operating income also benefited from a £223 million release of impairment allowance relating to the Protium Finance LP loan prior to consolidation.

Barclays Capital has cut operating expenses by £140 million. However, declining revenues mean its cost to income ratio has climbed from 60 percent to 65 percent.

RBS Half year total income is down 12.3 percent on the previous half year, falling from £3.7 billion to £3.3 billion, with the decrease attributed to reduced client activity due to sovereign concerns and the subsequent low risk appetite. The biggest fall was in fixed income and currencies revenues, which were 13.1 percent lower, as management reduced risk exposures in the division due to volatile market conditions, resulting in weaker client activity across all trading desks. Equities saw a smaller drop of 7.8 percent.

Meanwhile, the cost to income ratio for the investment banking arm has gone up from 49 percent to 60 percent period-on-period.



Lloyds Revenues of £374 million at Lloyds’ Treasury and Trading business remain consistent with the £355 million generated in the prior period. However, since Lloyds’ investment banking business is on a much smaller scale to the other UK banks, it is difficult to make comparisons, and so will not attract much commentary hereafter.

HSBC Fast-growing markets such as those in Latin America and Asia Pacific contributed significantly to HSBC’s results, helping to buttress the bank’s performance. Nevertheless, the challenging trading environment resulted in a more than 10.7 percent drop in revenue, from £5.0 billion at half year 2010 to £4.4 billion.

Credit revenues fell 49.2 percent compared to the first half of 2010 due to lower recoveries from securities investment conduits, a reduction in effective yields, lower holdings of legacy assets and lower client activity, as renewed Eurozone debt concerns hit client activity and widened credit spreads. Rates revenue was 11.4 percent lower due to lower favourable fair value movements on structured liabilities. Meanwhile, Balance Sheet Management revenues continued to decline, from £1.4 billion in the first half of 2010 to £1.1 billion. This reflects the roll off of higher yielding positions, with the low interest rate environment limiting reinvestment opportunities, coupled with lower gains from the available-for-sale portfolio in Asia Pacific.

Operating expenses increased due to continued investments in rates and foreign exchange e-commerce platforms, and higher compensation related deferral costs from the previous year and accelerated recognition of future deferred bonus awards. This, together with a decline in income, contributed to the increased cost efficiency ratio in its Global Banking and Markets business, which is up from 44.0 percent to 50.2 percent.

Standard Chartered Standard Chartered is once again bucking the wider investment banking trend. It reported a 5.4 percent increase in period-on-period operating income to $3.4 billion. Revenue from commodities and equities almost doubled on the back of ongoing volume growth, especially in energy and precious metals, as clients managed their exposures to volatile market conditions. Revenue from foreign exchange also increased by 19.1 percent, thanks to strong trade volume and demand for RMB products.

Across the bank as a whole, Standard Chartered has pledged to control cost growth so it is in line with income growth over the course of the year.

Common themes Several common themes have emerged through the first six months of the year:

Declining revenue Most banks’ half year results have deteriorated compared to the previous year, with much of the slowdown happening in the second quarter. The revenue drop has been most marked in banks’ Fixed Income, Currency and Commodities (FICC) businesses, which have suffered from a slump in trading volumes stemming from the Eurozone debt crisis.


Going forward, banks will have to wrestle with a host of external changes and challenges, which appear set to have a permanent dampening effect on performance


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Increasing costs In general, cost to income ratios have been rising. Operating expenses are up, in part as a result of rising employee compensation ratios – for example, due to competition for talent in growth markets, and as changing remuneration practices increase banks’ fixed cost bases. Investment in new businesses and infrastructure to generate future growth has been another factor. However, falling revenues are mostly to blame for the deteriorating cost efficiency ratios.

Revenue constraints, and rising capital requirements, are forcing banks to institute sweeping cost-cutting programmes in a bid to hit return on equity targets. The programmes include a swathe of job losses, with the announcement of up to 50,000 job cuts in the next three years across all UK banks globally. A number of the cuts will impact the investment banking divisions.

Eurozone debt crisis As negotiations around the Greek bailout become ever more fraught, and contagion fears intensify, the resulting lack of market liquidity and rising sovereign spreads in the Eurozone have led to significant market volatility, lower trading transactions and reduced client demand.

Alongside the impact on trading volumes, RBS and HSBC also took a hit in impairment charges. HSBC Group recorded a modest £65 million charge (£40 million recognised within the Global Banking and Markets business) against Greek sovereign and agency exposures. However, RBS booked a £733 million provision against its Greek government bonds, equivalent to almost half the total of its holdings. By comparison, Société Générale and BNP Paribas took a 21 percent charge on their Greek government debt, which is based on the outcome of the subsequent restructure.

Challenges ahead Going forward, banks will have to wrestle with a host of external changes and challenges, which appear set to have a permanent dampening effect on performance.

Sovereign debt As well as depressing the half year results, sovereign debt issues will continue to be a major challenge for the future. Markets remain worried about Greece’s long-term solvency. More importantly, fears have now spread to Spain and Italy, causing yields on their respective 10-year bonds recently to hit their highest levels since the launch of the Euro.

As the third and fourth biggest economies in the Euro area, Italy’s and Spain’s woes have enormous potential repercussions for global growth and the entire banking system. Yet doubts over the viability of the Eurozone’s current support facilities mean a satisfactory resolution to the crisis remains a long way off.



As the graph below shows, banks have significant exposures to Eurozone sovereign debt (excluding Lloyds’ and Standard Chartered’s exposures which are immaterial).

Sovereign debt (billion GBP)

6.0

4.0

2.0

0

-2.0 Portugal Italy Ireland Greece Spain

Barclays HSBC RBS


Meanwhile, the recent Congressional stand-off in the United States raised uncomfortable questions over the country’s debt levels, its credit rating, the standing of US Treasuries and the dollar, and its ability to drive future global growth.

Future strategies Focusing on expanding activities in emerging economies and strengthening their presence in existing market areas remains the core strategy for a number of banks.

In addition to its emerging markets focus, HSBC plans to continue developing its Prime Services and equity market capabilities, and expand its rates and foreign exchange e-commerce platforms. Standard Chartered is developing its capabilities in areas such as commodities and equities, as well as the mining and transportation sectors. As well as investing in its existing franchises, RBS also intends to focus on broadening its equities and emerging markets capabilities.

And across the board, cost management will remain a theme as banks endeavour to rein in cost to income ratios.



2011 Outlook Recent events suggest the financial crisis may be back with us, only now instead of a banking crisis it is evolving into a sovereign one. Rising bond yields among key Eurozone member states, the stalling US recovery, fears of stagflation in the UK, widespread fiscal consolidation, and precipitous equity market falls around the world make for a gloomy outlook. With sovereign debt worries sparking funding difficulties for banks, there are now fears of a second credit crunch.

Whether these fears materialise remains to be seen. However, these are increasingly uncertain times and trading conditions for the rest of the year are likely to remain tough. With such uncertainty afflicting the West, banks will become ever more dependent on emerging market businesses for growth. But with all participants increasingly competing for the same markets and customers, clearly not everyone can be a winner.

Conclusion After a promising start to 2011, subsequent events – notably the resurgent Eurozone debt crisis – served to depress most banks’ results. With market fears becoming increasingly intense through July and August, the outlook appears much the same for the rest of the year as well.

In this challenging market and regulatory environment, investment banks will need to step up their efforts to control costs and source more reliable areas of revenue generation.



Cutting costs gains new urgency

Cost control has taken on a new priority at the UK’s banks. Since the crisis, market participants have been grappling with cost to income ratio strains and a more challenging regulatory and competitive landscape. And with revenue growth becoming increasingly difficult to source, bank executives have stepped up their focus on cutting costs wherever possible in a bid to make their organisations more efficient and agile.

Costly times As the graph below shows, average (unweighted) cost to income ratios have increased to 58 percent in the first half of 2011 from 53 percent in the corresponding period of 2010, before taking account of the Lloyds PPI charge (which is excluded from the quoted cost to income ratio).

Cost to income (percentage)


80

60

40

20

0


A: H1 2009 B: H2 2009 C: H1 2010 D: H2 2010 E: H1 2011


In response, a number of banks have commenced aggressive cost reduction programmes, with a desire to get cost to income ratios into the 40 to 50 percent range.

Why do banks have cost issues? The problems with the cost efficiency ratios stem from a combination of factors on both sides of the cost to income equation:

Revenue Banks are struggling to grow top line revenues across many areas of their businesses. As we noted in the last Benchmarking Report, with interest rates at historic lows in the UK and many other Western economies, banks continue to face intense pressure on liability margins with stiff competition for deposits to improve


Banks are spending huge sums on reviewing and re-engineering processes and systems to meet regulatory requirements


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funding sources. The uncertain economic conditions, with limited prospects for GDP growth across the European Union, and the imposition of more stringent loan criteria by banks, means personal and business demand for lending also remains subdued, negatively impacting margins.

Meanwhile, after the highs enjoyed in 2009, income from investment banking trading activities slowed during 2010 and has slumped through the first half of this year.

Cost Alongside the revenue constraints, banks have been facing significant cost headwinds. They stem from a variety of factors, but two issues stand out in most banks’ analysis.

1. Business investments To achieve growth in revenues, a number of institutions are seeking to expand their emerging market operations. Whilst this is probably a good bet from a revenue perspective, it may push up cost to income ratios in the short term.

For example, Standard Chartered’s operating expenses grew 13.4 percent in 2010 and a further 7.7 percent in the first half of 2011. The rise was primarily driven by staff expenses as the bank competes for talent in its target markets, but also reflects infrastructure spend on new branches and enhancement of distribution channels.

HSBC has been through a prolonged period of expansion and now operates in 87 markets and in each one offers a comprehensive product and service suite. However, scale brings recruitment requirements in competitive markets, complexity and replication of organisational structures, processes and IT infrastructures, which has given rise to cost challenges.

At a recent investor seminar12, Rich Ricci, Co-Chief Executive Officer, Corporate and Investment Banking (CIB) at Barclays, said it has been investing in the business since 2008, with its cost base expanding accordingly. However, “the majority of this investment has now been made and our costs have stabilised,” he added.

2. Regulation A catalogue of national and international regulatory initiatives in the wake of the financial crisis is continuing to add to the cost line. Banks are spending huge sums on reviewing and re-engineering processes and systems to meet regulations, including employing more staff to engage with policymakers, and bolstering compliance and risk management departments.

Meanwhile, new EU remuneration rules have led banks to raise base salaries to compensate for restrictions on bonus pay-outs, embedding higher fixed costs into their operations.

12. Barclays Investor Seminar, 15 June 2011. © 2011 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. 13. Includes certain other customer redress costs.


Additionally, the total redress bill for Payment Protection Insurance (PPI) – as banks’ recent provisions demonstrate – will be in the billions, and has a significant impact on the cost line for the first half of the year.

PPI provisions (billion GBP)

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0

Barclays RBS Lloyds HSBC13 Std. Chtrd.


Lastly, the Government announced in February that it would increase the bank levy to £2.5 billion this year, further adding to banks’ costs for the second half of the year (not provided in the first half).

Barclays estimated its slice at £350 to £400 million per annum. HSBC said its liability this year will be $600 million (£375 million). RBS’ forecasts are for £320 million in 2011, while Lloyds expects a bill of £260 million for 2011 and Standard Chartered expects $180 million to $200 million (£110 million to £125 million).



Cost cutting targets All the banks are trying to bring long-term cost to income ratios down to 40 percent or below if possible; a number of industry participants have initiated substantial cost cutting programmes:

• Barclays has identified up to £2 billion in potential savings by 2013, with a savings target of £1 billion at Group level. This includes £500 million savings through to 2013 at RBB (net of restructuring costs) and reducing run rate costs in its CIB businesses by between £250 million and £300 million by 2013

• Lloyds is targeting annual cost savings of £1.5 billion per annum in 2014 (£1.7 billion of run-rate savings by end 2014). This is on top of £2 billion of run-rate cost synergies and other operating efficiencies by the end of 2012 stemming from its earlier HBOS integration programme. The Group is targeting a cost to income ratio of 42 to 44 percent by the end of 2014

• HSBC is targeting $2.5 billion to $3.5 billion of sustainable cost saves in three years, giving a 48 to 52 percent CER (cost efficiency rate, equivalent to the cost to income ratio) by 2013

• RBS reported that it is running ahead of its target to deliver annual savings of £2.5 billion by 2011 while further opportunities to reduce costs will be pursued.

Banks’ target cost to income ratios will become more achievable as interest rates rise and income profiles improve. Nevertheless, with regulation driving up costs and limiting revenue generation in historic business areas, and competition between existing players and new market entrants intensifying, cost optimisation pressures will only continue. In this environment, banks’ success in managing costs will be a key determinant of their future competitiveness.

Key features of the recently announced cost reduction programmes are:


Barclays • Right-shoring operational roles • Removing management layers • Consolidating functions • Cutting duplication and integrating management, support functions and infrastructure as much as possible

• Relocating to lower cost centres • Limiting discretionary spending

Lloyds • Redesign processes to increase automation and materially reduce the number of IT applications • Increase distribution platform efficiency by rationalising product suite and migrating to digital distribution channels

• Cut supplier numbers from around 17,000 to under 10,000 to save 15 percent on addressable spend

• Create more agile organisation by delayering management structure, centralising control functions and simplifying the legal structure. A further 15,000 job losses – on top of the 28,000 announced to date

HSBC • Implement consistent business models to standardise the Group’s propositions • Implement 20 key efficiency projects • Streamline multiple layers in local, regional and global structures and optimise the balance between them. Includes cutting Head Offices, delayering and migrating processes to low cost locations

• Reduce IT spending


4. Asset quality

Jon Bingham, Banking Audit Partner

Continued reduction in loan impairment charges has propped up the banks’ results again this period – but is it sustainable? In this section, we summarise the key balance sheet trends which have given rise to the £4 billion aggregate reduction in loan impairment charges compared to the first half of 2010.

Most banks continue to benefit from customers deleveraging their personal and corporate balance sheets. However, certain sectors within the loan portfolio remain susceptible to future interest rate rises and fluctuations in consumer demand, particularly retail and real estate.

Recognising these potential future risks, and with new buyers entering the market, non-core loan sales are increasingly on the agenda for many financial institutions.

In this chapter

Impairment 24

Balance sheet 29

Non-core loan sales emerge 33


Asset quality


Impairment

All banks reported reductions in their impairment charges during the first half of 2011, compared to the first half of 2010, against a backdrop of rising uncertainty over the strength of the economic recovery and concerns over sovereign debt exposures.

The first half of 2011 has been a relatively quiet period for impairment losses, with most banks benefitting from customers continuing to deleverage their (personal and corporate) balance sheets, particularly in highly indebted Western economies that continue to experience historically low interest rates. However, the big question remains, will this continued deleveraging sufficiently reduce the risk in bank portfolios in time for a possible rise in interest rates (caused by inflationary pressures or international sovereign risks)? Many sectors of the UK economy remain fragile, particularly retail and real estate, and could give rise to increased losses in the second half.

Whilst sovereign risk has been a big feature in the markets, other than for RBS, losses to date from sovereign exposures (mainly Greece) have been limited. However, with combined exposures of £20.2 billion to Eurozone economies there are very high stakes at play.

Impairment expense

Impairment expense (billion GBP)

10.0

8.0

6.0

4.0

2.0

0

A: H1 2009 B: H2 2009 C: H1 2010

RBSBarclays

A B C D E A B C D E

D: H2 2010 E: H1 2011

Lloyds

A B C D E A

HSBC

B C D E

Std. Chtrd.

A B C D E


Combined impairment charges for of all the banks reduced by 21.2 percent to £14.9 billion compared to £18.9 billion during the same period in 2010; Barclays topped the list with a decline of 40.6 percent, followed by HSBC at 30.0 percent.



Barclays reported an impairment charge of £1.8 billion compared to a charge of £3.1 billion in the first half of 2010, reflecting improving credit conditions. The largest fall came in Corporate and Investment banking where impairment charges reduced from £1.3 billion to £500 million. Excluding a release relating to Protium of £223 million, the reduction in impairment charges was driven primarily by lower impairment charges in Spain of £299 million, £134 million below the first half 2010 charges, and a 27 percent decrease in Barclaycard impairment losses, to £648 million following increased customer repayments.

RBS’ reduction in the impairment charge of 2.1 percent to £5.1 billion compared to 30 June 2010 is mainly attributable to its Non-Core book, where impairment losses reduced by £600 million driven by the planned run-off of assets. Impairments fell in both Core and Non-Core businesses across the majority of divisions, with the exception of Ulster Bank and Global Transaction Services. The Ulster Bank Group impairment charge increased to £730 million from the £499 million charge reported for the first half of 2010 due primarily to the impact of declining collateral values related to property. RBS recognised an impairment charge of £733 million in respect of Greek government bonds, amounting to 50 percent of the notional amount held.

Loan impairment charges at Lloyds were 17.2 percent lower than the first half of 2010 at £4.5 billion, with new impairment charges taken against commercial real estate exposure in Ireland offset by substantial improvements elsewhere in the group. The reduction was mainly attributable to the Wholesale portfolio where impairment charges reduced significantly from £2.8 billion to June 2010 to £1.5 billion for 2011 driven by HBOS heritage corporate real estate portfolios. Retail impairment charges reduced by £200 million to £1.2 billion, primarily as a result of improved credit quality in the unsecured loan portfolio. International exposures partially offset the above improvements, with further impairment charges in both Ireland and Australia due to concerns over the commercial real estate market in Ireland and falling property values in the Australasia region. These factors contributed to an increase in impairment charge for the International segment of £300 million to £2.5 billion.

Loan impairment charges of $5.3 billion were 30.0 percent lower at HSBC for the half year to 30 June 2011 compared to the same period last year. This was driven primarily by lower impairment charges for HSBC Retail Banking and Wealth Management in the US. In the UK loan impairment charges in retail and commercial portfolios declined as a result of continued low interest rates, which resulted in an improvement in delinquency levels.

Lower delinquency trends were also behind the 5.7 percent reduction in impairment charges to $412 million reported by Standard Chartered for the period. In percentage terms, this is towards the lower end of the percentage movement in loan impairment charges amongst the five banks and may indicate a more normalised (and significantly lower) level of impairment charge for the bank, which did not experience the same level of increase in the last few years.

Whilst impairment charges have improved across all the banks, significant concerns remain over exposures to certain Eurozone countries. During the first half of 2011, some banks disclosed impairment charges in respect of Greek sovereign and agency exposures classified as available for sale, reflecting the further deterioration in Greece’s fiscal position and the recently announced support measures.



Impaired assets Impaired assets as a percentage of gross loans and advances to customers increased at Barclays, Lloyds and RBS but decreased at HSBC and Standard Chartered.

Impaired loans compared with gross loans and advances to customers (percentage)

12

10

8

6

4

2

0 A B C D E A B C D E A B C D E A B C D E A B C D E


A: H1 2009 B: H2 2009 C: H1 2010 D: H2 2010 E: H1 2011


At RBS, impaired assets have increased by £3.8 billion (9.7 percent) to £42.4 billion. The majority of this increase (£3.2 billion) related to Ulster Bank’s commercial real estate and mortgages portfolio. Coupled with the decline in gross loans and advances of £10.6 billion, the ratio of impaired assets to gross loans and advances to customers rose to 8.3 percent compared to 7.3 percent at the end of 2010.

Barclays’ impaired assets decreased by 3.2 percent to £23.6 billion at 30 June 2011 (excluding the £7.6 billion loan to Protium), reflecting higher write-offs and exits in the UK, which were partially offset by deteriorating conditions in Portugal and Spain for Barclays Corporate. In Retail, customer deleveraging and risk management activities resulted in a decline of 4 percent to £12.1 billion. At the same time gross loans and advances to customers rose by 3 percent to £453.6 billion compared to 31 December 2010.

Lloyds reported impaired assets of £65.5 billion for the half year ended 30 June 2011, which remained broadly flat when compared to the £64.6 billion as at 31 December 2010, due to higher impaired assets in Wealth and International banking being partially offset by declines in other businesses. The ratio of impaired assets to closing advances has remained broadly stable at 10.6 percent compared to 10.3 percent at the end of 2010.

Impaired assets declined at HSBC by 7.4 percent to $26 billion as at 30 June 2011 driven by the continued run-off of the consumer lending and mortgages business in the US. The percentage of impaired assets to loans and advances to customers declined to 2.5 percent from 2.9 percent as at the end of 2010, helped further by the rise in gross loans and advances to customers, particularly in Asia and Europe.



Standard Chartered’s impaired assets increased by 4.6 percent to $4.3 billion driven by increases in consumer banking. The impaired asset percentage at 1.6 percent of lending is the lowest amongst the banks in our report.

Impairment cover HSBC and Standard Chartered continue to have the highest impairment coverage ratio of the banks.

Impairment cover on impaired loans and advances to customers (percentage)

100

80

60

40

20

0

A: H1 2009 B: H2 2009 C: H1 2010

RBSBarclays

A B C D E A B C D E

D: H2 2010 E: H1 2011

Lloyds

A B C D E A

HSBC

B C D E

Std. Chtrd.

A B C D E


Barclays’ total impairment allowances decreased by 6.5 percent to £11.6 billion as at 30 June 2011, representing reduced impairment in Spain as a result of actions taken by the bank in 2010, and a reduction of Barclays’ impairment in Business and Retail Banking. Impaired assets decreased by 3.2 percent and, paired with a slightly smaller reduction in provisions, Barclays’ coverage ratio (excluding Protium) decreased from 51.0 percent as at 31 December 2010 to 49.2 percent at 30 June 2011.

Impairment cover for RBS increased by 193 bps to 48.7 percent at 30 June 2011 from 46.8 percent as at 31 December 2010. Impaired assets increased by 9.7 percent, mainly reflecting continuing difficult conditions in both the commercial and residential real estate sectors in Ireland, as Ulster Bank was the predominant contributor to this increase. In the same period, RBS increased its provisions for impaired assets by 14.4 percent.



Lloyds reported a 70 bps decrease in its impairment coverage ratio to 45.2 percent as at 30 June 2011 from 45.9 percent as at 31 December 2010, as the bank’s provisions increased at a slower rate than the impaired assets, particularly in Wealth and International, reflecting the continued deterioration in real estate values in Ireland and in Australasian property markets to which Lloyds is exposed.

HSBC’s impairment coverage increased by 66 bps from 72.1 percent as at 31 December 2010 to 72.7 percent. Both impairment provisions and impaired assets fell, chiefly reflecting the continued run-off of its consumer portfolios in North America.

Standard Chartered reported a decrease in its impairment coverage ratio to 63.4 percent as at 30 June 2011 from 64.8 percent as at 31 December 2010. Impaired assets increased in the consumer banking sector, partially offset by a modest increase in provisions.



Balance sheet

Balance sheet shape and development for the banks in this report continues to be split between those with significant state investment and those focused on growth in targeted areas. While the pace of run-off of the non-core portfolios has decreased leading to more stable total assets at some banks, other banks with significant interests in Asia have seen continued and steady growth.

Total assets (billion GBP)



2,000

1,500

1,000

500

0

A: H1 2009 B: H2 2009 C: H1 2010 D: H2 2010 E: H1 2011


Following the 2010 year end results we commented on the mixed story in total assets, with decreases at RBS and Lloyds due to the continued run-off of loan portfolios compared to increases at the other banks which targeted growth in lending. This same distinction can be made during the first half of this year, although the rate of decrease has slowed at the banks with significant state investment.

Lloyds has reduced its non-core assets from £194 billion at the end of 2010 to £162 billion at the half year. The most significant decrease by asset class was in its Treasury Assets which decreased from £49 billion to £29 billion. Further non-core asset disposals including the EU mandated retail business disposal which is required to complete by the final quarter of 2013 are expected over the next couple of years. Lloyds targets non-core assets of less than £90 billion by end of 2014.

RBS continues to run down its Non-Core portfolio, which has decreased from £138 billion at year end to £113 billion at half year. Significant progress has been made across its portfolio and the most significant asset classes now are Corporate and Commercial Real Estate, which amounted to £50 billion and £37 billion (or 45 percent and 33 percent of the Non-Core portfolio) respectively. In its announcement RBS confirms that the sale of its UK branch-based businesses to Santander continues to make good progress and that it is expected to complete in the second half of 2012 subject to regulatory approval. RBS notes that it is on track to reduce third party assets to below £100 billion by the end of the year and targets Non-Core assets of £30-40 billion by the end of 2013.



Loans and advances Customer lending has remained mixed in the first half of the year. RBS and Lloyds were impacted by weak demand and continued to actively decrease assets through the running down of non-core portfolios, while others continued to pursue growth in targeted lending, most notably HSBC and Standard Chartered – the banks with more significant interests in the Asia Pacific region. More generally the shift to secured lending continues, as customers pay down their unsecured borrowings.

Loans and advances to customers (billion GBP)

800

600

400

200

0

A: H1 2009 B: H2 2009 C: H1 2010

RBSBarclays

A B C D E A B C D E

D: H2 2010 E: H1 2011

Lloyds

A B C D E A

HSBC

B C D E

Std. Chtrd.

A B C D E


Barclays’ loans and advances to customers increased by £14.0 billion (3.3 percent) to £442 billion with growth in both wholesale and retail lending. Wholesale lending grew by 4 percent driven by increased settlement balances, partially offset by the reduction in loans resulting from the consolidation of Protium. Retail lending grew by 2.7 percent due to growth in home loans in the UK and Italy and also the acquisition of Egg consumer card assets which added £2.3 billion of receivables.

Lloyds reported that loans and advances to customers decreased by £21.4 billion (3.6 percent) to £568.1 billion, excluding reverse repos. The decrease was driven principally in the Wholesale and Retail divisions which were 7.6 percent and 1.6 percent lower respectively. Lloyds states that, despite continuing to meet its lending commitments in respect of gross new lending, its net lending has reduced as a result of weak demand for new credit and continued customer deleveraging.



At RBS loans and advances to customer decreased over the first half of the year by £13.2 billion (2.6 percent) to £489.6 billion, excluding repurchase agreements and stock borrowing. This was driven principally by the planned significant reduction in the Non-Core portfolio of £13.9 billion as it is run down, as well as a decrease in its Global Banking and Markets business. These were partially offset by net lending in other areas, including its Global Transaction Services and UK and US retail businesses.

HSBC reported an 8.0 percent increase in gross loans and advances to customers to $1,056.6 billion, with growth in all regions, except North America, compared to December 2010. Approximately one-third of the increase related to currency translation as a result of the weakening of the US dollar. The underlying growth in customer loans and advances was most notable in corporate and commercial lending (the largest lending category at 46.5 percent of gross lending) which benefited from growth in business and trade activity, particularly in Asia Pacific and Europe. The increase in personal lending was more modest, and reflected higher mortgage balances in Hong Kong and the UK. This was partially offset by the run-off of the consumer portfolios in the US and a reduction in credit card advances as customers continued to pay down debt.

Standard Chartered has continued to grow loans and advances steadily, with an increase of 9.1 percent to $262.1 billion. The growth has been across both the Consumer and Wholesale Banking businesses and in all significant geographic regions. The growth in Consumer Banking reflected increased demand for unsecured lending in Asia Pacific and the acquisition of GE Money Singapore which added $1.5 billion of receivables. Standard Chartered reported that mortgage growth had been more muted due to the economic uncertainty, periodic rate hikes and tougher competition. The growth in Wholesale Banking was particularly notable in Hong Kong, which included the effect of increased demand across mainland China following the internationalisation of the Renminbi.

Some banks have included an update in their announcements on their commitment under the Project Merlin, the agreement between five major banks (Barclays, RBS, Lloyds, HSBC and Santander) to help support the UK economic recovery. Barclays, Lloyds and HSBC all confirm that they remain on track to achieve their lending goals under the agreement, which include amounts to small and medium sized businesses. RBS confirms that it is committed to supporting its UK customers and the UK economy as a whole and notes that it makes available lending facilities considerably in excess of its market share.

Funding and liquidity Improving their loan to deposit ratios and reducing reliance on wholesale funding has continued to be a focus for the banks during the first half of the year. Competition for savings balances remains tough against the backdrop of continued low interest rates across the globe.

HSBC and Standard Chartered continue to stand out with the lowest loans to deposits ratios, both of which have been relatively stable at just under 80 percent, with growth in lending broadly being matched by new customer deposits. All of the other banks have ratios in excess of 100 percent but have all improved their position over the first half of this year.



Each of the banks has increased its customer deposit balances, and in some cases this has been significant. However this has largely been in low rate, instant access accounts rather than term deposits. The focus remains on moving to longer term deposits whilst yields remain relatively low, both to enhance the maturity profiles and lock in favourable rates.

Whilst Lloyds continues to have a loan to deposit ratio significantly higher than the other banks it continues to reduce its reliance on wholesale funding. During the period it reduced by some £59.5 billion its liquidity support from government and central bank sources. A further £37.1 billion remains due, which is expected to be repaid in line with contractual maturity dates through to October 2012. During the period it raised £25 billion from term funding.

The other banks have also been proactive in refinancing wholesale funding in advance of due dates as well as increasing the maturity profile. During the period, term funding was issued at Barclays (£19 billion), RBS (£18 billion) and HSBC ($18 billion).

The level of cash held at central banks increased significantly at all banks except Barclays, as excess liquidity levels increased. Despite the 11.0 percent decrease at Barclays, at £86.9 billion, it continued to have the largest cash balance.

Overall, whilst funding and liquidity have continued to improve, they can be expected to remain areas of critical focus for the foreseeable future, as the banks build liquidity buffers and the required infrastructure to ensure compliance with the FSA Liquidity Regime.


In a constrained capital environment, disposing of adequately provisioned loan portfolios may prove to be an attractive solution


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Non-core loan sales emerge

Following the onset of the financial crisis in 2007, the UK non-core debt sale market has begun to gather steam over the past six months. A number of banks and financial institutions have begun formal sale processes for their loan portfolios, while others are undertaking informal market soundings in preparation for potential future sales.

Recent high profile sale processes include those undertaken by Bradford & Bingley, RBS (in Spain and the UK), Citibank and GMAC. These transactions have spanned commercial real estate backed, residential mortgage and consumer finance loans.

In addition, several other institutions are currently engaged with external investors to gauge pricing and potential deal structuring.

Similarly, the Irish non-core debt sale market shares many of the same characteristics as the UK. It too has seen a recent uptick in loan sale activity, particularly in relation to non-domestic ‘non-core’ assets held by Irish banks.

Macroeconomic environment In May independent forecasters expected prevailing interest rates to rise in the medium term14. Whilst this seems less likely, it could lead to higher defaults and could further suppress real estate demand and prices.

In a constrained capital environment, disposing of adequately provisioned loan portfolios may prove to be an increasingly attractive solution for banks.

Vendors For vendors, many of the transaction drivers include:

• Upcoming Basel 3 capital requirements

• Compliance with European Commission state aid requirements

• UK banks’ ongoing focus on deleveraging, exiting non-core markets and/or products and aligning loan maturities with available funding.

However, constrained market pricing, relative transaction inexperience and a dearth of strategic buyers have resulted in a paucity of successful ‘quick exits.’ Indeed, banks that have recently conducted transactions (particularly those with larger performing portfolios) have often incurred significant P&L pain, or have discontinued the process so as to avoid such impact.

Buyers Barclays’ acquisition of Citi’s Egg portfolio in March 2011 marked the first major strategic portfolio transaction in many years. Aside from this, UK banks and building societies have shown little interest in buying their peers’ assets. What interest does exist is largely confined to high quality consumer loans that are complementary to the buyer’s existing customer profiles and are capable of external financing.

While few strategic banking purchasers exist for those non-core performing assets currently earmarked for future sales, the sector has seen the emergence of longer

14. Forecasts for the UK economy: a comparison of © 2011 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG independent forecasts, HM Treasury, May 2011. network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.


term financial buyers, such as pension funds, insurance companies and sovereign wealth funds who are looking to invest in longer term, lower risk loan portfolios.

For vendor banks the appeal of these new buyers is obvious: deep pockets, lower return requirements and experience in the credit investment space. However, questions remain as to whether they will continue as passive investors through private equity and investment banking vehicles, or step up to become outright purchasers of non-core banking assets (at suitable prices for vendors).

NPL consumer debt market direction The UK consumer NPL market has reached a fork in the road. Down one path is the ‘old market’ of 2006 and 2007, characterised by regular, small portfolio sales. The other leads to a ‘new market’ dynamic in which large overseas investors pursue large portfolios.

Old market The UK unsecured debt purchase sector has seen a revival in loan sale activity. In part this has been driven by vendor banks marketing smaller portfolios that had, until recently, relied on additional collection cycles. These portfolio sales generally are conducted via auction to a panel of debt purchasers, targeting buyers that were able to withstand recent challenges experienced in the Debt Collection Agency (DCA) and Debt Purchaser (DP) markets.

However, most buyers are only able to purchase relatively small portfolios and often lack either the funding or capability to acquire larger portfolios (in the range of £300 million face value), which would help vendor banks clear their warehoused loans, reduce their capital and improve liquidity.

New market Increasingly, large global investors are seeking to access the UK unsecured debt purchase market by structuring partnerships with existing DCAs/DPs. The drive by these investors stems in part from the potential to secure larger investments (in the £400 million plus range) and different loan types (such as first or second lien mortgages, unsecured personal loans, and IVAs), which have not been as available hitherto.

For vendors the investor demand presents opportunities to sell larger portfolios of consumer NPLs and other loan types. The growing use of ‘back books’ created from reduced sale volumes from 2008 to 2010 further enhances the prospect of conducting larger sales with the option of forward flow agreements.

Meanwhile, a number of DPs are exploring with vendors the potential of specific deal structures (such as profit sharing, stapled financing and joint ventures) that may reduce the bid-ask gap.

It remains to be seen whether vendors will revert to ‘old market’ style transactions to dispose of their accumulated back books, or if they can leverage the size of their current warehouse portfolio, access to other debt types, or dynamic deal structuring to drive forward flow arrangements. But with banks facing profitability pressures, and looming capital and funding constraints, significant asset sale progress in either direction will be a welcome move.



5. Regulatory and accounting change

Giles Williams, EMA Head of Regulatory Centre of Excellence

Condensing the vast regulatory and accounting change agenda into a short summary is a real challenge. The adequacy of banks’ regulatory capital remains in the spotlight: whilst all banks surveyed passed the European Bank Authority stress tests in July and disclosed stable or improving capital ratios in their interim results announcements, there remains pressure to strengthen their capital bases in the future.

More broadly, the Chancellor George Osborne’s public endorsement of the Independent Commission on Banking’s proposals in June suggests that ring-fencing of UK retail banking activities is now a likely outcome – this could have a profound impact on business models in the future.

There has been a wave of new accounting standards precipitated by the reaction to the financial crisis. Many argue that these standards will have a more significant impact than the initial implementation of International Financial Reporting Standards in 2005 and will fundamentally re-write banks’ balance sheets.

In this chapter Capital adequacy 36

Where to draw the line around ICB proposals? 39

CRD 4: Basel 3 with a twist 42

IFRS brings wave of change 45


Regulatory and accounting change


Capital adequacy

Capital management remains a key focus and challenge for banks. There remains political and public pressure to increase lending and the regulatory requirement to strengthen capital positions continues to evolve. Whilst there has been continued focus on capital management in the period, there has been little by way of capital raising. Instead capital positions have been driven by retained profits or lower levels of risk weighted assets.

On 15 July 2011, the European Banking Authority released its aggregate report on the results of the EU-wide stress test exercise. The objective was to provide regulators with information for assessing the resilience of the EU banking system to adverse, but plausible, economic developments and the ability of banks to survive potential macroeconomic shocks.

Barclays, HSBC, Lloyds and RBS all passed the test, which set a benchmark for Core Tier 1 capital at 5 percent of risk weighted assets. Standard Chartered was not included in the tests. The table compares the actual ratios at 31 December 2010 to the projected ratios in 2012 under the adverse scenario before any mitigating actions.

EBA EU-wide stress test – Core Tier 1 capital ratios (percent)

Barclays RBS Lloyds HSBC

Actual at 31 Dec 2010 10.8 10.7 10.2 10.5

Projected at 31 Dec 2012 7.3 6.3 7.7 8.5

HSBC’s Core Tier 1 ratio was projected to be 8.5 percent under the adverse scenario at the end of 2012, which was higher than the other UK banks, where the projections ranged from 6.3 percent (RBS) to 7.7 percent (Lloyds). HSBC’s Core Tier 1 ratio was also projected to be least impacted by the adverse shock with a decrease of 2.0 percentage points, compared to the other UK banks which decreased between 2.5 percentage points (Lloyds) and 4.4 percentage points (RBS).

Following significant strengthening in capital ratios in 2009 and 2010, the movements in the first half of 2011 have been more modest or in some cases marginal.



Core Tier 1 ratio (percentage)

12

10

8

6

4

2

0 A B C D E A B C D E A B C D E A B C D E A B C D E


A: H1 2009 B: H2 2009 C: H1 2010 D: H2 2010 E: H1 2011


The Core Tier 1 ratio at Barclays’ increased to 11 percent which reflected the impact of the reported profit for the period. Barclays’ risk weighted assets were broadly unchanged, allowing for foreign exchange, with reductions from the sell down of legacy assets in Barclays Capital being offset by increases from the acquisition of Egg and regulatory methodology changes during the period.

RBS’ Core Tier 1 ratio increased from 10.7 percent at the 2010 year end to 11.1 percent despite the loss reported. This was as a result of the decrease in risk weighted assets of £32.0 billion (6.9 percent) as it continues to manage down risk positions in its Global Banking & Markets business and run down and dispose of non-core operations. The benefit to the Core Tier 1 ratio from the Asset Protection Scheme remained unchanged at 1.3 percent.

The Core Tier 1 capital ratio at Lloyds decreased marginally to 10.1 percent, with the impact of the reported loss for the period being largely offset by the reduction in risk weighted assets of £23.1 billion (6 percent). The movement in risk weighted assets in the period was driven by the run-down of the non-core asset portfolio. Lloyds notes that it expects the effect of the continued run-down in the second half of the year to be offset by the impact of the implementation of the new Capital Requirement Directives 2 and 3 rule changes.

The increase at HSBC from 10.5 percent at year end to 10.8 percent at half year can be explained primarily by profit generation, which more than offset the impact of an increase in risk weighted assets of $65.4 billion (6 percent). HSBC estimates that $16.2 billion of the increase in risk weighted assets is due to currency translation as a result of the weakening of the US dollar, and the remainder predominantly reflects increased lending in Asia Pacific and Latin America.

Standard Chartered’s Core Tier 1 ratio increased marginally to 11.9 percent. This reflects the impact of the reported profits being partially offset by the increase in risk weighted assets as a result of increased lending particularly in its Wholesale Banking business, most notably in Asia and, to a lesser extent, in its Consumer Banking business.



Risk weighted assets (billion GBP)

800

700

600

500

400

300

200

100

0



A: H1 2009 B: H2 2009 C: H1 2010 D: H2 2010 E: H1 2011


Regulatory change Later in this chapter we discuss the significant volume of regulatory change facing the banks, including the latest draft of the Capital Requirements Directive (CRD 4) and Basel 3. The banks in our report have disclosed to varying degrees the expected impact of the new requirements:

• RBS notes that the indicative impacts of the proposals are unchanged from those disclosed at year end, when it was estimated the impact would be to lower the Core Tier 1 ratio by approximately 130 basis points after mitigation and deleveraging, assuming risk weighted assets of £600 billion and a Core Tier 1 ratio of 10 percent

• Lloyds notes that it expects the rules changes to have a negative effect of approximately 80 basis points on Core Tier 1 capital by the end of 2013

• HSBC has estimated the impact of the rules, as they would apply at 1 January 2019 but based on the position at 30 June 2011, would result in a common equity Tier 1 ratio which is lower than Basel 2 Core Tier 1 ratio by some 170 basis points (allowing 100 basis points from mitigation action planned by management)

• Standard Chartered estimates that proposed amendments to Basel 2 and the introduction of Basel 3 will reduce its future Core Tier 1 capital ratio by approximately 100 to 110 basis points

• Similar to year end Barclays did not provide an indication of the potential effect of these regulatory changes but confirmed that it would continue to generate internally any additional capital that will be required to hold or meet regulatory change over the coming years.



Where to draw the line around ICB proposals?

The ICB’s ring-fencing proposal gets the Chancellor’s backing, but serious operational question marks remain.

In a month’s time the Independent Commission on Banking (ICB) will publish its long-awaited recommendations. The big question is will it leave banks with the ability to create a coherent, and profitable, operating and business model?

Following Chancellor George Osborne’s public endorsement at his Mansion House speech in June, the ICB’s interim proposal for ring-fencing UK retail activities appears the likely outcome. At this stage it is unclear where the line around retail banking is to be drawn, and how banks will structure their operational and business models in the post-ICB world. Yet forging a workable solution is essential if the UK’s financial sector is to remain a vibrant contributor to the country’s economy.

Divergent views All stakeholders agree on the need for a safe, effective financial sector, but getting the balance between ‘safe’ and ‘effective’ – for there will be trade-offs – is critical, and remains a contentious issue. For while on the one hand there is the political imperative to take action to protect depositors and critical economic functions, the risk is that it will impose severe costs on the industry that ultimately will hurt customers and the real economy.

At this stage the discussions indicate that insured UK retail deposits will have to be undertaken in a ring-fenced UK retail bank, while retail banks will not be allowed to provide capital market, investment and risk management services for large corporates, governments and other financial institutions. But this leaves question marks over what happens to the mass of activities in the middle, including non-insured retail deposits, corporate deposits and corporate lending, retail investment and advice services, and trade and project finance.

A spectrum of ring-fence options has been proposed. These include creating legally separate entities, having fully operationalised and independent subsidiaries, and using separate standalone groups to provide infrastructure support, legal services, technology, treasury functions, etc to the ring-fenced and not ring-fenced entities. Some respondents to the ICB’s interim report favour a narrow ring-fence. Others argue for the inclusion of an array of corporate banking activities.

Building society template According to the ICB, a small number of respondents suggested the Building Societies Act could serve as a potential ring-fencing template, especially in defining the use of hedging instruments. In particular, news reports15 indicate the ICB is focusing on how retail banks’ treasury departments would function within the ring-fence, to ensure there is no overlap with proprietary trading activities.

A possible solution In light of such divergent views, and the banks’ varying business models, a solution may be to introduce a flexible ring-fence that institutes a capital cost trade-off for firms according to where the line is drawn around their activities.

15. ICB eyes building society model for ring-fencing retail bank operations, by Harry Wilson, Daily Telegraph, © 2011 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG 9 July 2011. network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.


Key concerns The ring-fencing discussions have raised a host of concerns over how it can be put into practice. Among the key issues are:

Moral hazard Stephen Hester, chief executive of RBS, argued during the Treasury Select Committee (TSC) hearing in June that ring-fencing would increase systemic risks, reduce banks’ ability to withstand those, and bring significant costs. He pointed out it was primarily retail or commercial loans that were the root of banks’ problems during the crisis. Ring-fencing, and so giving taxpayer guarantees to these parts of the business, could then create moral hazard by promoting higher-risk retail lending. In addition, credit rating downgrades could result from limiting the diversification of banks’ earnings and funding.

Governance Improving bank governance has been a key challenge post crisis. Will the ring-fenced entity have a totally separate board, or share board governance? How would the influence of the group over the retail bank be managed? Would central functions such as risk management, internal audit, legal and treasury have to be duplicated? If so there are sizable cost implications.

Tax If a ring-fenced UK retail bank is treated separately from the rest of the group for tax purposes:

• It may take longer to utilise tax deductible losses against future profits

• There will likely be higher overall VAT costs

• Ring-fencing of assets and liabilities will require a careful approach to funds transfer pricing

• If overseas branches are split into a retail branch and investment banking subsidiary there are potential implications for the distribution of tax payments between the UK and overseas.

Investment banking As a non ring-fenced, riskier business, investment banking would face much higher capital requirements. Banks may find it difficult to raise the necessary capital, and so pull back from activities that are beneficial to the wider economy.

Meanwhile, if resolution plans fail to achieve an orderly winding up or restructuring, and if bail-in debt is insufficient to meet losses, then both government intervention and taxpayer support might still be required if a systemically important investment bank fails. Furthermore, the contagion impact on the confidence of retail depositors will make it difficult to insulate a UK retail bank from problems arising from its non-retail activities.

Business model Whatever the eventual content of the ICB’s report, its recommendations and the wider regulatory reform agenda are set to change the business models for retail, corporate and investment banking.



Priority issues banks will need to address include:

• How might customers, counterparties, shareholders and rating agencies respond to the ring-fencing of retail activities, and the reduced implicit government guarantee on non-retail banking activities?

• How will it affect the availability and cost of each business line’s funding?

• What changes will be required to product development and pricing across retail, corporate and investment banking? How will it affect the profitability and/or availability of products and services?

• How can services to larger corporates be maintained effectively if there is a split between the retail bank and wider group?

• What are the tax implications of any restructuring, and operating on an ongoing basis through separate entities dealing on an arms-length basis?

Integration with recovery and resolution plans (RRPs) Another crucial consideration concerns international proposals for RRPs. For the outcomes to be effective, it is important there is alignment between the global approach to systemic institutions – and the legal entity rationalisation it will provoke – and the ICB’s final ring-fencing recommendations. Banks will then need to marry the two when formulating policies.

Removing uncertainty While ring-fencing in some form appears to be the likeliest result of the ICB’s deliberations, a full Glass-Steagall-style separation of retail and investment banking operations may yet be an option16. For banks such suggestions bring more unwanted uncertainty.

It is essential, therefore, that with publication of the ICB’s recommendations in September firms can move forward free of the doubts that have been hanging over the industry. If not, banks will face an even bigger challenge to build up their capital positions in preparation for the transition to Basel 3.

16. Full Glass-Steagall back on ICB agenda, by Juliet © 2011 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG Samuel, City A.M., 21 July 2011. network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.


CRD 4: Basel 3 with a twist

The latest revision to the Capital Requirements Directive, CRD 4, is largely based on the Basel 3 package, but comes with some important European Union-specific additions. Furthermore, firms and regulators face a crucial challenge in integrating implementation of the CRD 4 measures with the raft of other regulatory reform initiatives taking shape.

Harmonised Regulation In contrast to the previous Capital Requirements Directives, CRD 4 is to be implemented via a combined Regulation and Directive. By using a ‘maximum harmonisation’ Regulation, the standards will take direct effect across the European Union without needing to be transposed into national legislation or national regulatory rules. As a result, there will be no discretion for national variation in the standards – which the European Commission hopes will ensure a level playing field, achieve a true single rule book and strengthen the functioning of the EU single market.

EU add-ons In most respects the substance of the CRD 4 Regulation and Directive – which is due to come into force at the beginning of 2013 – will reflect the Basel 3 package of tougher capital and liquidity standards and enhanced risk weightings. However, the Directive also contains a number of supplementary measures.

Corporate governance Changes to corporate governance practices include:

• Separating the chair and chief executive roles (unless authorised by the national supervisor)

• Limiting the number of directorships an individual may hold

• Establishment of a nomination committee to review the composition and performance of the board and the ability of its individual members

• Establishment of a risk committee, and a strong and independent risk management function

• Creation of a remuneration committee, with remuneration policies to follow the Financial Stability Board’s principles.

Minimum administrative sanctions EU-wide minimum common standards are to be introduced for, inter alia, the key violations to which sanctions should apply (breaches of authorisation, prudential and reporting requirements), the types of sanction available to national authorities, and the magnitude of financial penalties.



Supervision National supervisory authorities will have more responsibilities as well. This includes taking proper account of the leverage and liquidity ratios, and following good supervisory practices such as closely monitoring firms’ internal models, and undertaking annual assessments and stress testing. In addition, supervisors will need to strengthen collaboration and information sharing with their counterparts in other countries.

Adopting Basel 3 For the rest, CRD 4 adopts many of the same measures as Basel 3. Key components include:

Capital definition Greater emphasis on common equity Tier 1 (CET1) capital, and a tighter definition of what can be included as ‘additional tier 1’ capital (hybrid instruments that share some of the characteristics of debt and equity).

Capital deductions These will be more wide-ranging, more harmonised and mostly tougher.

Additional buffers The Regulation essentially replicates the Basel 3 agreement’s capital ratios and their phasing-in. This includes allowing national authorities to apply a counter-cyclical buffer of more than a 2.5 percent increase on the CET1 capital ratio.

Risk weightings There are tougher risk weightings in the trading book for some areas of market risk (securitisations in particular) and counterparty credit risk exposures. The Regulation allows for a review to take account of the BCBS’ consideration of whether trade finance should be subject to more beneficial capital requirements, which is expected to be finalised later this year.

Leverage ratio Firms will need to report their leverage ratio to national supervisors from 2013, and disclose it publicly from 2015. The ratio is due to become a binding Pillar 1 requirement from January 2018.

Liquidity The Regulation sets out reporting requirements for the new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) during the ‘observation periods,’ ahead of implementation of the LCR in 2015 and the NSFR in 2018. Meanwhile, firms will have to maintain a buffer of high quality liquid assets in any case as soon as the Regulation comes into force – effectively introducing the LCR or a national equivalent ahead of its official implementation in 2015.

However, the EU sovereign debt crisis raises question marks as to whether government bonds can be treated as high quality liquid assets, and if they need to be ‘funded’ under the NSFR. These issues will be reviewed as part of the ratio observation periods.

Credit ratings The Regulation introduces a marginal reduction in the use of credit ratings to calculate capital ratios, while external ratings for corporate bonds will be used to assess high quality liquid assets for the purposes of the LCR. Firms will need to develop internal methods for assessing credit risks so as not to rely solely or mechanically on external ratings.



“ Regulatory initiatives cannot be viewed simply as extra layers of regulation that can be introduced independently of each other ”

Key issues for firms i) Technical standards The European Banking Authority (EBA) will play a central role in developing the large number of binding ‘technical standards’ that set out the detail of how many of the regulatory and reporting requirements in the Regulation and Directive are to be applied. Firms will need to keep track of, and actively input into, the EBA processes to ensure the technical standards incorporate industry views.

ii) Reporting More specifically, firms will need to remain alert to the significant increase in reporting requirements set out in the Regulation, and consider whether they are able to integrate these requirements with other changes in regulatory reporting and data management.

iii) Broader reform agenda As discussed elsewhere in this report, firms (and regulators) also need to consider the broader array of regulatory reforms being developed, and how they will impact on each other.

The Regulation and Directive only cover the Basel 3 package, and do not explain how this will relate to:

• Capital surcharges for global and national systemically important financial institutions

• The fundamental review of the trading book being undertaken by the Basel Committee on Banking Supervision (BCBS)

• The use of macro-prudential tools, other than the counter-cyclical capital buffer

• The EU’s proposed Crisis Management Directive, recovery and resolution plans, and ‘bail in’ debt.

It is imperative these initiatives are not viewed simply as extra layers of regulation that can be introduced independently of each other. Rather, their combined impact needs to be assessed carefully and the measures adjusted accordingly. This should include an analysis of the potential unintended consequences of the regulatory reform agenda, including its overall impact on lending and the real economy, the consequences for the cost, availability and fragility of funding, and how it will affect the growth of the shadow banking sector.



IFRS brings wave of change

The array of new International Financial Reporting Standards (IFRS) recently released or in a late stage of development will institute a raft of accounting rule changes over the next few years. Many argue they will have far more impact for financial institutions than the initial IFRS implementation in 2005. Together, this so called ‘second wave’ will fundamentally rewrite banks’ balance sheets, affect their regulatory capital positions and require major changes to systems and processes.

Crisis-led reform The financial crisis exposed critical weaknesses in business practices and financial regulations. As a result, the G20 Summit in April 2009 called for urgent and broad-based reforms, including significant improvements in financial reporting. Together the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) established the Financial Crisis Advisory Group to act on this agenda, producing a number of key recommendations:

• Improve standards for the valuation of financial instruments based on liquidity and investors’ holding horizons, while reaffirming the framework of fair value accounting

• Reduce the complexity of accounting standards for financial instruments

• Strengthen recognition of loan loss provisions by incorporating a broader range of credit information

• Improve accounting standards for off-balance sheet exposures and valuation uncertainty

• Drive towards a single set of high quality global accounting standards

• Improve involvement/engagement of stakeholders and regulators in standard setting.

Headline changes A series of new accounting standards have been, or are being, finalised:

IFRS 9 Financial Instruments The project to replace IAS 39 with IFRS 9 Financial Instruments began in November 2008 and is still ongoing. There are three phases:

1) Simplifying the classification and measurement of financial instruments into those to be held at fair value with movement in the income statement, and those to be held at amortised cost.

2) Instituting a new methodology for recognising credit impairment that captures future expected losses, rather than only those already incurred, thereby ensuring firms recognise losses sooner. However, crafting an acceptable impairment model is proving problematic, and the IASB is now on to its third attempt.

3) Revised hedge accounting rules are also being drafted, with the objective of making hedge accounting simpler and aligning this to how firms actually manage their risk.



While only Phase 1 has been released in final form, the IASB’s goal is to finalise IFRS 9 in the second half of this year, although some elements – such as macro hedge accounting – may well emerge in 2012. EU endorsement is still pending as well.

The IASB recently announced a proposal to delay mandatory adoption to 1 January 2015. This is good news for banks given their dawning awareness of how much implementation work there is ahead of them, but in reality there is little or no respite in the pace of the financial change agenda.

“ Banks only have a short period in which to get their houses in order”

IFRS 10 Consolidated Financial Statements The financial crisis post-mortem raised concerns that existing consolidation and disclosure standards failed to fully capture risks to which investors were exposed.

Under IFRS 10, an investor will consolidate another entity when there is a clear link between decision making powers and exposure to variability in returns. The standard also distinguishes between principal and agency relationships, and introduces the concept of de facto control rather than majority share ownership in the consolidation decision.

This standard will impact all investment management activity by banks and their subsidiaries, and introduces new rules for determining whether Structured Entities (formerly Special Purpose Entities or ‘SPEs’) require consolidation. Given the number of SPEs used by banks (many thousand at some firms), determining how to apply the new rules is likely to be a Herculean task.

IFRS 11 Joint Arrangements IFRS 11 addresses cases where an entity has joint control over an investee or operation. The new rules mean a company no longer has a free choice between a one-line pick-up of their net share of a joint venture entity (‘equity accounting’) or inclusion of its share of each asset, liability, revenue and expense individually (‘proportionate consolidation’).

Moving from proportionate consolidation to equity accounting for affected joint arrangements will affect each of a company’s financial statement line items, notably decreasing both revenue and gross assets.

IFRS 12 Disclosure of Interests in Other Entities The IFRS 12 standard accompanies IFRS 10. It contains requirements for institutions to provide more disclosures regarding transactions they undertake with unconsolidated SPEs. Its boundaries remain unclear, but the extent of required disclosures could be significant.

IFRS 13 Fair Value Measurement The IASB project pre-dates the crisis but has been influenced by the heated debate that ensued. Developed by IASB and FASB in a bid to formulate a converged standard, IFRS 13 provides guidance for firms on how to measure the fair value of instruments, as well as establishing disclosure requirements to provide users of financial statements with more information about fair value measurements.

Assuming EU endorsement, IFRS’ 10 to 13 will become effective from 1 January 2013, with the comparative period starting on 1 January 2012. Therefore, banks only have a short period in which to get their houses in order.



On the horizon Other changes being discussed under Wave 2 include:

Leasing At present most banks’ branch networks are held on operating leases, which remain off-balance sheet. The proposed new rules would see leases come on-balance sheet, bringing a potential regulatory capital impact.

Revenue recognition Under the proposed new standard, fee-based contracts will need to be evaluated for any deemed ‘modifications’ that may change the pattern of revenue recognition. In addition, performance-based fees will need to be evaluated to see if the performance-to-date is predictable enough to recognise revenue during the performance period.

Offsetting financial assets and liabilities Previous proposals to align US Generally Accepted Accounting Principles (GAAP) with IFRS could have resulted in US banks’ balance sheets being grossed up by perhaps trillions of dollars. While the decision has been made not to pursue alignment, both IASB and FASB are considering requiring disclosure that would show how to reconcile US GAAP to IFRS as it relates to US registrants’ netting position.

Standards convergence Convergence between IFRS and US GAAP remains an objective, but in a more watered-down fashion. Rather, the phrase now being used is ‘condorsement’, to denote a mix of convergence and endorsement. As a result, the new standards will retain the US GAAP designation – rather than being called IFRS – where that is the case today, while reserving the right to tweak the standards where it is deemed appropriate.

Assets P&L Equity Disclosures

Consolidation • Significant gross-up where no funds exception • Significant additional disclosures for unconsolidated structured entities

Securities • Higher volatility where instruments move to fair value through P&L

Loans • Increase in impairment provisions from incurred to expected loss at transition

Leases • Most leases expected to move on balance sheet

Offsetting • Significant gross down now expected only in notes to financial statements to reconcile with US GAAP

Revenue recognition

Increase in volatility where: • Fee based income subject to modification accounting

• Certain performance-based fees disallowed from recognition until end of performance period



Next steps Implementation of IFRS 10 to 13 is looming. However, complying with the standards will be no easy task. The complexity to be found in the detailed rules, and onus on applying judgement, means institutions will have to think carefully about the choices they make and how that impacts their business model.

Meanwhile, the IFRS 9 standards are still being written. The quandary for banks is whether to wait for the rules to be finalised, or start making changes to systems and processes now in order to have sufficient time to be ready. Whatever the approach, institutions need to start taking some immediate steps:

• Start planning and budgeting for the required changes

• Think about the operational impact on systems and processes

• Start planning a programme to effectively inform, mobilise and educate people to facilitate a smooth implementation

• Plan to get an early indication of the impact on the presentation of results and balance sheets. This may help with decisions on early adoption, and allow informed commentary on further exposure drafts.

IFRS Wave 2 is more than an accounting exercise; it is crucial banks are prepared.



6. Banking innovation and the future

David Sayer, Global Head of Retail Banking

The future of UK banks’ business models have become a lot more uncertain in the last six months; anaemic economic growth in Western economies will provide little shelter from the profound effect on profitability of new regulation. Whilst retail banking has been grappling with the combined impact of the low interest rate environment and the ruling on PPI, investment banking volumes slowed markedly in the second quarter of 2011.

In these times of uncertainty, the natural reaction may be to hunker down and wait for conditions to improve. However, with developments in technology and customer behaviour it is important to take a serious look at a number of innovations – mobile services, social media and personal financial management – as critical weapons in the fight for customer profitability.

In this chapter Investing in innovation 50

Economic update 54

Outlook 57


Banking innovation and the future


Investing in innovation

Delivering innovative solutions to customers is essential to banks’ long-term profitability. However, making the necessary investments to keep pace with the rapid development of new technologies is easier said than done in the resource and cost-constrained environment in which firms are operating, and will continue to operate for the foreseeable future, as new regulations bite and margins remain squeezed. So how should organisations direct their investment spending?

Innovation drivers The natural tendency during such challenging times might be to hunker down and wait for conditions to improve. The problem is banks cannot afford to sit tight, for various reasons:

• The technology landscape is changing rapidly. For example, new internet capabilities, smartphone developments and a wealth of apps are coming downstream

• Consumer behaviour is changing. Increasingly people are turning to the internet, and mobile internet in particular, for a host of tasks, as they take advantage of the speed and convenience it offers. Customers are using new types of interactive, on-demand technology tools that offer compelling and engaging experiences (e.g. social networking sites and mobile apps) in their everyday personal and professional lives, and they expect banking to follow suit

• New entrants – whether new high street rivals or pure-play internet banks – have innovation built into their offerings from the outset. Traditional banks cannot afford to wait before responding to these competitive threats

• Changing business models – prospective ring-fencing of retail banking operations will have ramifications for the profitability of banking organisations for the foreseeable future. Meanwhile, the death of Payment Protection Insurance, and the lack of an equally profitable replacement, has left banks scrambling for alternative revenue sources. Therefore, firms need to reformulate their business models if they are to achieve target returns on equity.

There are three key areas of innovation on which banks should focus:

• Mobile services

• Social media

• Personal financial management.


By 2014 more than half of UK consumerswill adopt mobile banking


Mobile services There is a compelling case for banks to invest in mobile technologies. The numbers speak for themselves: the Future Foundation predicts that by 2014 more than half of UK consumers will adopt mobile banking and be carrying out much more sophisticated transactions using their handheld device17. Jupiter Research has estimated there will be over 400 million mobile banking customers globally by 2013; mobile payment users are showing a similar upward trajectory.

“

” Mobile payment users by region (in thousands)

Region 2009 2010

Western Europe 4,519 7,127

North America 1,905 3,502

Asia Pacific 41,865 62,828

EMEA 16,823 27,091

Latin America 5,131 8,010

Total 70,243 108,558

Source: Gartner, June 2010

Meanwhile, the combination of increasingly sophisticated mobile devices, banking services and payment options offers banks the opportunity to:

Gain market share By enhancing the customer service experience, market leaders will be able to attract retail and corporate customers away from slower-moving rivals.

Tap into new revenue streams The mobile banking ecosystem is evolving and there will be new revenue opportunities for those banks with a clear focus on this area. For example, banks that are evolving their mobile banking platform to facilitate remote payments are starting to secure new revenue streams from services such as mobile ‘top-up’ accounts and securities trading. Uptake of mobile payments should also increase the number of non-cash transactions processed by banks. For corporate customers, some banks are generating revenues by bundling enhanced services such as cash management tools and key back-office functionality.

Reduce their overall cost to serve customers. As the graph on page 52 shows, in the US, mobile offers a low cost alternative compared to other channels.

17. Emerging Trends in Mobile Banking, by the Future © 2011 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG Foundation, commissioned by Monitise, May 2011. network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.


Transaction costs by banking channel

$0.08

Call Centre

Branch

IVR

ATM

$4.00

$3.75

$1.25

$0.85

Online $0.17

Mobile

Source: Tower Group, Fiserv, Mcom data, 2009

Social media KPMG’s most recent Media and Entertainment Barometer survey18 found that social networking and blogging remain the most popular online activity. Half of all respondents participate, including one third of the over-55s.

However, retail banks are way down the social media adoption curve compared to other B2C sectors. A Datamonitor report19 reveals that:

• 60 percent of the world’s retail banks have no plans to use social media in any way

• Just 6 percent of retail banks use social media to deal with customer queries

• Only 14 percent currently use it for marketing, with a further 12 percent planning to use it to promote their business by the end of 2012.

The power of brand communities: Banks are missing an important trick by ignoring the power of social media.

18. Smart moves for new media: How is smart technology shaping ‘new media’? KPMG LLP UK, June 2011.

19. The Impact of Social CRM on Retail Banking, by Ovum (Datamonitor’s technology arm), February 2011.

Source: Universal McCann 2011 © 2011 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

Myths Facts Of people who joined a brand community online…

Social media Social media now is just a

passing fad permeates every part of

our day to day lives 72% thought more

66% felt more loyalty

toward the brand positively of

the brand

Social media appeals only to young people

Generations of all ages are now actively involved

in social media

71%

If you don’t participate in social media it can be

controlled

Conversations about your brand are happening with

or without you

63% recommended

others to join the brand

were more likely to buy the brand


“ Key PFM benefits to banks are: greater product holding, brand involvement and customer loyalty ”

An effective social media strategy can help banks improve their:

Marketing: By building awareness of the brand and product offering to enable the viral spread of brand communications.

Customer service: Social media networks and connectivity have the potential to transform support costs, while communicating transparency.

Product development: The community building capabilities of social media enable customers to become involved in product research, and thus help create products more tailored to customer demands.

Personal financial management (PFM) PFM is part of a wider ‘game-ification’ trend, in which game mechanics extend into non-gaming applications.

PFM typically uses rich visual interfaces that allow customers to track and analyse their spending and create budgets. By offering a more compelling user experience than traditional online banking, customers become more engaged with their finances and consequently with their bank, helping to increase the ‘stickiness’ of those relationships. Additionally, since PFM provides much richer spend data, it creates enormous opportunities for banks to offer products and services much better aligned to customer needs.

Some banks, such as Lloyds and Wells Fargo, have started to offer PFM either by building from scratch or using a white label solution (e.g. Yodlee, Geezeo). Other banks should consider how to follow their lead.

Innovation principles New innovations are emerging constantly. As a result, it is difficult for institutions to predict which will offer the best business opportunities, and so in which technologies to invest.

In the absence of a crystal ball, it is essential to have a process in place that enables banks to respond to changing trends and technologies faster and more effectively. This includes:

• Fostering a creative mindset and being forward-looking

• Implementing agile development processes

• Accepting and being prepared for failures

• Ensuring clarity on governance

• Killing projects mercilessly where appropriate.

Investing in innovation brings risks; but it has never been more essential.



Economic update

The global economy has deteriorated this year as the recovery which began in 2010 has lost momentum, particularly in advanced economies, and inflation has accelerated, notably in the emerging markets. By and large emerging markets were largely unaffected by the financial crisis and continued to boom. By contrast, in most advanced economies output remains below pre-recession levels and unemployment is proving to be stubbornly high. Meanwhile, credible long-term policies to reduce sovereign debt on both sides of the Atlantic are necessary to avoid further depressing activity or, in a worst case, de-railing the recovery completely.

Weakening growth The IMF still expects global growth of 4.5 percent in 2011, but growth forecasts have been trending lower in light of the slowdown since the start of the year. Whether the current weakness is just a soft patch, or the precursor of something more serious, remains to be seen. However, with interest rates around zero in the advanced economies, and governments under pressure to cut high deficits, room for policy manoeuvre is limited.

Temporary soft spot? At least some of the slowdown can be put down to one-off factors whose impact can be expected to diminish.

• Japan – the earthquake, and subsequent tsunami and nuclear disaster disrupted activity directly in Japan and, via supply chains, around the world. After a steep initial fall, Japanese output is already starting to pick up

• The ‘Arab Spring’ – political turmoil in the Middle East has pushed up oil prices and affected market confidence. The hope is that political and economic uncertainty will be short-lived

• Rising commodity prices – food and energy price inflation is depressing real incomes and dampening consumer spending. However, to the extent this reflects temporary supply interruptions, inflation should eventually subside and the squeeze on incomes should ease.

Long-term fundamentals On the other hand, there are concerns that dull growth may be the best that can be expected now the special factors producing the initial recovery – the turn in the stock cycle and supportive fiscal and monetary policy – are fading. The financial crisis and recession may have damaged both demand and supply potential, limiting the headroom for a bounce-back in the short term and permanently reducing sustainable growth rates in the long term.



Sustained retrenchment There is evidence that recessions following financial crises have tended to be sudden and deep, and recoveries slow and weak. On the supply side, capacity may be permanently reduced as factories and businesses have closed, investment has slumped and long-term unemployment has risen, effectively reducing the viable labour force.

On the demand side, higher savings propensity may reduce consumer spending as over-extended borrowers seek to rebuild balance sheets ravaged by asset price falls, while under-capitalised lenders de-lever in the face of bad debts.

Country snapshot

UK After four quarters of recovery, output has been broadly flat since last autumn. Anaemic growth since the turn of the year has only just reversed the surprise 0.5 percent GDP fall in the fourth quarter of 2010. Confidence and business activity measures have declined as fiscal austerity measures kick in. Job losses have started to pick up, although employment has continued to expand at the same time. Inflation is well above target, but the MPC has resisted raising rates for fear of choking off recovery.

The overhang of debt from the consumer and housing market booms, falling real incomes and austerity measures are depressing domestic demand. The necessary rebalancing of the economy away from consumer and government spending towards exports and business investment is underway, but is threatened by the global slowdown in general and weakness in the main European export markets in particular. Given the scale of public sector retrenchment and the challenges facing consumers, recovery will likely be a long and difficult road.

Eurozone After 1.7 percent growth in 2010, driven predominantly by Germany, the euro area grew 0.8 percent in the first quarter of this year alone – but this looks like the peak of the recovery. Significant challenges remain in the periphery, and even in the core recent data indicate growth is slowing. Some of the softening in the core can be attributed to government efforts to reduce deficits, but the major wildcard remains the sovereign debt crisis, where longer term solvency and competitiveness issues remain.

US After a poor start to 2011 US Federal Reserve Chairman Ben Bernanke has accepted that the recovery has suffered a loss of momentum. Recent figures showed job creation stalling and the jobless rate rising again. As with many developed countries, the US has limited monetary room for manoeuvre to stimulate growth. The recent furore over the debt ceiling negotiations would seem to rule out a renewed fiscal boost, and whilst a further round of quantitative easing cannot be ruled out, this is likely only as a last resort.

Japan Activity is recovering as supply-side disruption and the blow to confidence caused by the earthquake, tsunami and nuclear disaster earlier this year ease. Nevertheless, the sharp downturn immediately following the quake suggests GDP could fall by up to 1 percent this calendar year before bouncing back in 2012.

Emerging markets Growth rates remain impressive, but there are tentative signs that activity in China and other emerging markets is slowing as central banks take steps to curb inflation. For example, in July the Bank of China raised benchmark interest rates for the third time this year. Persistent inflation in India has also led to a succession of rate rises.

Going forwards, reduced demand from advanced economies could subdue export markets, which have helped fuel emerging economies’ growth. At the same time, a slowdown in the emerging markets will damage recovery prospects in the West. Both are increasingly dependent on each other.



Fiscal and monetary policy Initially as the private sector retrenched fiscal policy was allowed to take the strain to prevent recession turning into depression. But ballooning government deficits have resulted in a reversal of policy, with austerity measures being implemented in many countries. The clear risk is that these public sector cutbacks are coming before the private sector has restored its finances sufficiently to start spending again.

So far the UK and US have kept monetary policy loose in the hope it will promote private sector spending and offset fiscal tightening, but it is uncharted territory, and interest rates will rise eventually, as is already happening in the EU.

Eurozone debt crisis Plan ‘A’ to deal with the sovereign debt crisis in the peripheral European economies – austerity measures together with temporary liquidity assistance – did not work. To be successful, new initiatives will have to include not only acceptable burden-sharing arrangements – divided essentially between creditors, and domestic and overseas taxpayers – but also credible programmes to boost growth in the highly indebted countries.

Power shift Whether the current weakness in the advanced economies is just a blip or a structural shift is still uncertain. What is clear is that the two speed world is becoming more pronounced. Emerging economies powered into the crisis and most came out relatively unscathed. By contrast, many advanced economies stumbled into and out of the downturn. The shift of economic power from West to East has accelerated.



Outlook

The future of UK banks’ business models has become a lot more uncertain in the last six months. Following publication of the Independent Commission on Banking’s interim proposals, and their subsequent backing by the Chancellor George Osborne, ring-fencing of retail banking operations appears ever more likely. Meanwhile, the death of Payment Protection Insurance, and the lack of an equally profitable replacement, has left banks scrambling for alternative revenue sources.

Investment banking volumes have slowed markedly and there is a sense the surge in activities in 2009 and early 2010 reflected the temporary impact of quantitative easing rather than a sustainable recovery in activity. The Eurozone and US debt uncertainties have reinforced concerns about the medium term outlook for trading. With the tightening of capital and liquidity regulations it is open to question as to how banks can achieve their target return on equity.

Economic outlook The UK economy shows every sign of delivering a ‘DRAG’ (deficit reduction, anaemic growth) outcome for the next few years.

Latest figures from the Office for National Statistics show the UK economy grew a mere 0.2 percent during the second quarter, with a heavy fall in industrial output and only modest expansion in the manufacturing, construction and service sectors. The quarter’s tepid expansion comes on the back of six months of stagnation.

However, the overall figures mask significant variations in the economic outlook between the South-East and the rest of the UK. Therefore, banks will need to focus on developing strategies that help them increase their market share in those areas of the country with the strongest growth story.

Going forward, a host of challenges will continue to dampen the country’s economic prospects:

• The UK government’s austerity programme will hit the real economy over the next 12 months, with a particularly severe impact in those areas where a high proportion of local GDP is government derived

• Deleveraging by the whole financial sector is on-going, and the increase in capital requirements, liquidity and regulation will continue to drive the trend

• Problems in the Eurozone remain a source of enormous concern, given various countries’ debt overload and the political ramifications of sharing that overload among member states

• China has been a powerful engine for global economic growth since 2008, but its intensifying efforts to curb inflation through a series of interest rate rises are now putting a brake on expansion. Inflationary countermeasures in India and other emerging markets are having similar impacts.

In the UK, long-anticipated interest rate rises now appear further off, following the drop in the Consumer Prices Index (CPI) – the Government’s target measure for inflation – from 4.5 percent in May to 4.2 percent in June. Recent energy bill hikes



“ If interest rates have to rise sharply to counter the threat of accelerating inflation the risk of a double dip recession will increase ”

will bump inflation back up again, but the recent CPI drop and concerns about the fragility of the economic recovery appear likely to stay the hand of the Bank of England’s monetary policy committee for the time being.

From a policy perspective, combining inflation-erosion of outstanding debts with low interest rates to stimulate growth appears a relatively attractive way of tackling current problems. However, there is real uncertainty as to how long this balancing act can be sustained. And if at any point interest rates have to rise sharply to counter the threat of accelerating inflation the risk of a double dip recession will become more likely.

Retail banking The big issue for retail banking in the first half of the year has been the conclusion of the Payment Protection Insurance (PPI) mis-selling legal case. The redress bill for the industry as a whole is expected to be in the order of £9 billion, a big one-off hit to profits. Perhaps even more importantly, it means retail banking needs to find a new business model.

PPI accounted for as much as 25 percent of the profitability of some retail banking divisions until just three years ago. Retail banks will struggle to replace this profitable income stream. As a result, coping with the transparency of the internet by surrounding a low headline APR rate with such an extremely profitable product is no longer a workable strategic position.

The second major issue will be the final recommendations of the Independent Commission on Banking (ICB) due out in September 2011. The ICB’s interim proposals, published in April, and backed by the Chancellor at his Mansion House speech in June, indicated retail ring-fencing is the most favoured outcome. Yet at this stage there is considerable ambiguity around what is meant by a ring-fenced retail bank. Critical questions remain over the extent to which it includes commercial and corporate banking functions, and to what degree retail deposits can be used to fund other activities. The content of the ICB’s final report, and how it is put into practice, will have implications for the profitability of retail banks for the foreseeable future.

Future challenges Net interest margins As we noted in our last Benchmarking Report, the profitability mix between retail banking products has shifted from fee income to net interest income in recent years. In particular, the focus has been on back-book mortgages, which have been the saviour of the UK’s retail banking sector.

However, as competition between the major banks for back-book mortgages intensifies, margins are more likely to fall than rise. Meanwhile, lack of activity in the housing market means there continues to be little new mortgage lending.

Impairments The spectre of rising impairments also looms. Although the extent remains to be seen, the government’s austerity package will force up unemployment in concentrated areas of the country. At some point, interest rate rises are also inevitable. The deadly combination of rising unemployment, higher loan repayments and falling house prices could then have a significant impact on impairments in mortgage books.



Firms are intent on re-energising bancassurance, to make the cross-selling of insurance products to their customer base work

“

Channel innovation The combination of new developments in internet and mobile banking pose real challenges for the positioning of retail banks over the next 10 years.

Internet banking Getting the right internet banking offering will be critical. A key component of success will be the launch of personal financial management (PFM) tools, for two reasons:

• Retail banking profits emanate from loyal ‘sticky’ customers. Providing customers with real information on the historic way in which their personal accounts have operated, using data from the banking systems, could help lock them in for the future

• So far banks have struggled to make the internet a sales channel. However, firms that get PFM right potentially will create a self-service sales channel, enabling them to prompt customers to consider products and investments which they may otherwise have not.

Mobile services Smartphones and tablets will be an increasingly important interface channel between customers and their banks in the coming years. Banks with the most user-friendly applications will have the opportunity to:

Gain market share By enhancing the customer service experience, market leaders will be able to attract retail and corporate customers away from slower-moving rivals.

Tap into new revenue streams For example, banks that are facilitating remote payments are starting to secure new revenue streams from services such as mobile ‘top-up’ accounts and securities trading. Uptake of mobile payments should also increase the number of non-cash transactions processed by banks. For corporate customers, some banks are generating revenues by bundling enhanced services such as cash management tools and key back-office functionality.

Reduce their overall cost to serve customers, as mobile is a much lower cost service channel.

Action responses To bolster their positions, banks are focusing on building out alternative sources of revenue and cutting costs.

Fee income Retail banks are demonstrating a real desire to obtain a significant proportion of income from fees rather than from lending. As the recent Lloyds strategic review highlighted, firms are intent on re-energising bancassurance, to make the cross-selling of insurance products to their customer base work.

Wealth management Most banks have announced strategies to increase their share of the wealth management market. However, not all players can be winners. There are big questions as to what will happen to pricing as competition increases. In addition,the Financial Services Authority has indicated it will increase its focus on this area to ensure wealth management divisions are being transparent with their ” customers on the risk profile of portfolios.



Channel management The success of institutions’ internet and mobile banking offerings – and the extent to which firms invest to keep pace with innovations – will be an increasingly important differentiator going forward.

The branch channel will also remain a major part of banks’ servicing proposition, serving as anchor points for banks in communities. However, the role of the branch will need to be redefined. In future, branches will be used far less for transactions, as more are captured by internet and mobile banking. Instead they must be used to provide more personal customer service, thereby reinforcing client relationships. In addition, they will serve as an important channel for selling more complex products, and as such will be central to firms’ bancassurance strategies. That naturally leads to branches being more focused on premier and wealth management customers – who tend to be older and prefer face-to-face contact.

Cost management Along with falling margins, new capital rules mean banks around the world have to fund considerably more capital and tie up more of that capital in less profitable, liquid assets. The resulting pressures are forcing banks to reduce costs and improve efficiency.

All banks are trying to bring long-term cost to income ratios down to 40 percent or below if possible. To achieve this, a number of industry participants have announced substantial cost cutting programmes.

Account charges Given the range of profitability pressures bearing down on the industry, the introduction of account charges in the UK at some point in the next few years has to be a real possibility. However, while the logic is evident, it is not so easy to see the actual mechanism that will trigger such a move. Could PFM prove to be the value-added ‘killer application’ that permits banks to introduce fee-based current accounts?



Investment banking After a promising start, the first half of 2011 proved very disappointing for investment banks on both sides of the Atlantic. Trading volumes have slumped, the rate environment has flatlined, banks’ convergence on the same strategic areas – equities, emerging markets, e-commerce platforms – has led to margin compression, and underwriting activity is subdued.

There are positives linked to the emerging markets and there will be transactions driven by the state aid agenda across Europe, but the overall sense from the interim reports is one of quite deep gloom.

Prospects for the immediate future are not attractive and the sector is facing major headwinds even if trading volumes move out of the doldrums. Increasing capital charges, funding constraints, curtailment of structured finance businesses, and general deleveraging and de-risking will make it structurally more difficult for wholesale banks to return to the profit levels seen in recent years. Meanwhile, tepid economic growth in advanced economies, some slowdown in emerging markets as authorities struggle to curb inflation, and the deepening Eurozone debt crisis provide a gloomy backdrop.

As for UK banks specifically, the upcoming ICB recommendations – be they for retail ring-fencing or even a full Glass-Steagall separation of retail and investment banking – further dampen the outlook.

Regulation Alongside the ICB report, there are many major regulatory initiatives confronting the banking sector, and there is much more to come:

• Additional capital and liquidity requirements for systemically important financial institutions

• Requirement for most major banks to implement recovery and resolution plans

• Tougher and better resourced supervision

• Macro-prudential oversight (including an as yet to be fully developed toolkit of regulatory measures and data collection)

• Tougher approaches to traded markets and conduct of business.

The immediate outcomes of these actions will be significant: more capital, lower leverage, more captive liquidity, possible structural change, fewer products and more intrusive (and costly) supervision. Many potential unintended consequences may also come from the interaction of these major changes in regulation. There will be a host of challenges to current business models and the continuation of the major deleveraging seen since 2008 appears probable.


FINANCIAL SERVICES

UK Banks:Performance

BenchmarkingReport

Half Year Results 2011

kpmg.co.uk

Contact us

Bill Michael UK Head of Financial Services Partner T: +44 (0) 207 311 5292 E: [email protected]

David Sayer Global Head of Retail Banking Partner T: +44 (0) 207 311 5404 E: [email protected]

Nigel Harman UK Head of Banking Partner T: +44 (0) 207 311 5291 E: [email protected]

The following people made significant contributions to this publication:

Principal editors: Jon Bingham, Phil Merchant and Mike Peck Content and/or analysis: Ian Anderson, Marty Carroll, Kara Cauter, Juliet Coukham, Lisa Fernihough, Steven Hall, Ruth Horgan, Andrew Jenke, Zaffar Khakoo, Matthew Lyon, Graham Martin, Michael McGarry, Dina Modha, Hugh O’Reilly, Andrew Smith and Giles Williams

www.kpmg.co.uk/banking

To provide feedback E: [email protected]

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

© 2011 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. Printed in the United Kingdom.

The KPMG name, logo and ‘cutting through complexity’ are registered trademarks or trademarks of KPMG International.

RR Donnelley | RRD-257408 | August 2011

mailto:[email protected]

http://www.kpmg.co.uk/banking




Financial Service UK Banks Performance Benchmarking Report HY Results 2011

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