Year in Numbers

Painful memories of the global financial crisis may still be fresh, but there is an almost tangible sense that the banking industry has finally got up the confidence to re-write the playbook. The world’s major banks have restructured and re-tooled. Marshalled by a tough new regulatory and supervisory regime, they have reduced risk-weighted assets, re-sized employee populations, rebalanced client portfolios, rebuilt product platforms, re-thought geographical footprints and redesigned IT, data management and other operational architectures. They are simpler and less fragmented organisations, better capitalised, less leveraged and more liquid. “We are getting toward the end of a regulatory super-cycle,” said Matthieu Lemerle, senior partner at McKinsey and the firm’s lead on European capital markets and investment banking. “From that point of view, regulators have achieved one of their primary goals, with much higher capital ratios than 10 years ago. If you see this as a proxy for the ability of banks to absorb shocks, then you have a much stronger and sounder banking sector than 10 years ago.” Getting to this point has not been easy. It has been a decade of looking backwards, trying to make the best of a bad situation, fixing poor governance and dealing with the consequences of bad, sometimes illegal and occasionally criminal, behaviour. The theme of cultural revolution in banks has arguably been over-engineered for effect. But US$300bn-plus in fines meted out to banks for crisis-era wrongdoing will have had their impact. As will US$100bn-plus in additional annual compliance costs the industry is estimated to have taken on. The key challenge for banks is how they break out of the period of low profitability. The long-run cycle of massive central bank liquidity stimulus via ultra-low interest rates and quantitative easing has crushed banks’ net interest margins, while the low-growth environment, regulatory restrictions and a degree of risk aversion have severely curtailed money-making opportunities. This has squeezed returns on much higher equity bases. “Banks are starting to realise that they cannot cut their way to greatness, and the old architecture of the industry is increasingly being disrupted by regulation, data and technology,” said Lemerle. ”The only response to this is offence, not defence. Banks need to look forward. They need to think about growth, about really transforming their operating model at scale, about new threats such as cyber and about a completely different people model. “The sector needs to raise its ROE above cost of equity. ROE is stable but unspectacular, especially in Europe, and revenues are moving sideways overall. Corporate and investment banks will need to find new areas of growth, which can be tricky in a market which is overall flat,” said Lemerle. ”But there are interesting niches to be found. The challenge is for individual banks to identify what will be relevant for them, where they can beat the competition – which increasingly includes new non-bank entrants – through innovative business models.” CHALLENGES, BUT NEW ONES With the US Federal Reserve already in tightening mode and the European Central Bank winding down its asset-purchase programme with expectations of a rate rise in autumn 2019, the underlying scenario is changing. Monetary authorities will remain cautious about the pace of rate increases and will be particularly keen to avoid any disorderly impacts from the normalisation of highly-distorted asset prices. The flow-through to higher margins and better bank earnings is definitely out there but it will be gradual. “It does feel like this cycle is fading and the benefit for banks’ profitability will be considerable. But the view looking forwards will still be challenging,” said Jonathan Wills, a partner in the corporate and investment banking practice of Oliver Wyman. &

The sale in June 2018 by the UK government of a 7.7% stake in Royal Bank of Scotland served as a stark reminder about how the fortunes of US and European banks have diverged since the financial crisis. The deal was highly symbolic for Europe’s capital markets bankers, not just because it resulted in a £2bn paper loss for the UK taxpayer a decade after RBS was bailed out, but because the investment banks selected by the UK government to handle the sale were all American. The RBS deal was just another opportunity for US banks to notch up another win on European soil, where they have already made record gains since the crisis. Globally, they have established a dominant market share in every investment banking product, according to analysis outfit Coalition: during the first half of 2018, US banks secured 62% of global investment banking revenues, while European rivals grabbed only 38%. There’s no doubt that US banks enjoy a number of structural advantages in investment banking. For a start, the US capital markets are the deepest and most liquid in the world, and account for half of global corporate finance fees, which are also higher than in Europe. US banks also took their medicine early, with the US Treasury forcing them to recapitalise in 2008 with the enforced Troubled Asset Relief Programme. The US authorities also encouraged consolidation as a response to the crisis, with Bank of America taking over Merrill Lynch, and JP Morgan buying Bear Stearns. “In the initial aftermath of the financial crisis US banks had a scale and capital advantage and were further helped by a domestic economy that has consistently grown over the last decade,” said Stephen Dainton, global head of equities at Barclays. And in the last 10 years, the S&P has risen by 300% while the Eurostoxx has climbed by a relatively sluggish 75%. “These structural advantages have enabled US banks to follow strategies that have been consistent,” said Dainton. During the same period, US M&A activity has reached new highs, and between 2016 and 2017 US debt capital markets posted three successive years of record volumes, factors that played to the strengths of big US universal banks with a home market advantage – and that allowed them to print money that can be put to use elsewhere. Now they are also becoming dominant in Europe, where many home-grown investment banks have taken a radically different approach. While US banks have pressed home their advantage, Europe’s banks have pulled in their horns, cutting huge swathes of their trading operations, exiting countries and product lines. In many ways, they only have themselves to blame. European banks were slow to adapt and as a result some are still trying to figure out their post-crisis future or have dialled down their commitment to investment banking. Ongoing restructuring means that European banks have suffered from strategic introspection, which has compounded their competitive disadvantage. As an indication of the level of upheaval, Deutsche Bank in April appointed Christian Sewing as its third CEO in six years. His predecessor John Cryan, who was ousted after struggling to turn the lender around, summed up the bank’s problems in January with his customary bluntness. “We began restructuring about five years later than the banks in the US,” he said. ”Unfortunately, we did not capitalise on our advantages after the financial crisis and adjusted our business model far too late.” DITHERING Deutsche’s dithering cost it its position as Europe’s top corporate finance house in terms of fees and, according to Refinitiv data, it now languishes in eighth position for the first three quarters of 2018, behind Credit Suisse and Barclays. All of the top five spots are occupied by US banks. While US banks have enjoyed a structural advantage, Europe’s investment banks have faced economic and regulatory headwinds. The region

The period since the global financial crisis has coincided with a time of heavy investment by Japanese financial institutions. Coming out of the upheaval of their own 1990s banking crisis and the economic torpor of the post-1990 period at home, Japan’s restructured and rejuvenated banks looked overseas for growth from an enviable position of strength. Mitsubishi UFJ Financial Group’s purchase of a 24.4% stake in Morgan Stanley and Nomura buying Lehman Brothers’ European and Asian businesses were the most high-profile examples of Japanese banks moving out into the world. But other banks acquired huge portfolios of assets from international players forced into panicked post-crisis deleveraging, in the process further globalising their geographical, client and product footprints. Mizuho’s acquisition of RBS’s North American loan portfolio, for example, added bankers in key areas such as debt origination and leveraged finance. Japan’s mega-commercial banks also acquired, bought strategic stakes in or arranged joint ventures with Asian banks to round out their offerings in fast-growing markets closer to home. “The Japanese banks are on our radar. They have had made a lot of progress in their non-Japan [CIB] growth strategies, even though 2018 has been a challenging year for them,” said the head of research at a leading market analytics firm. “Their focus is different to traditional investment banks; the Japanese mega-commercial banks are mainly focusing on lending, financing, corporate derivatives, and transaction banking products associated with traditional banking business lines.” In CIB, the three mega-commercial banks have led with their large balance sheets and have long been leading cross-border syndicated lenders. Refinitiv’s investment banking fee data (covering M&A advisory, DCM, ECM and syndicated lending) had the three megabanks plus Nomura in the top 25 global fee earners at the nine-month 2018 stage. Notably, Mizuho, MUFG and Sumitomo Mitsui Financial Group heavily outperformed the market: while the global fee pool fell 4.8% year-on-year, Mizuho increased its take by 12.8%, MUFG by 12.4% and Sumitomo by 9.1%, and they all gained market share. It is fair to say, though, that while the Japanese houses are slowly building better non-Japan DCM profiles (particularly Mizuho and MUFG), they are not yet competing on the top table and their international equity and advisory businesses lack scale. THORNY TASK Japanese banks need international profiles now more than ever given conditions at home, where BoJ stimulus has killed net interest margins (and undermined profits) and Japan’s ageing demographic has curtailed future business opportunities. But the thorny task confronting management now is not just building business profiles that are less reliant on lending, it’s weaving everything into a coherent – and more profitable – global whole with a convincing strategic back-story. The banks are working on transforming business profiles by selectively re-allocating capital to areas of higher return, and exiting unprofitable client relationships. Thorny because they are faced with achieving that amid parallel initiatives to cut costs, reduce headcount, and close branches at home. And they are attempting to do it against the backdrop of potentially tricky global market conditions and challenging industry headwinds. “The Japanese banks focused on lending as a gateway to entry, using access to cheap funding,” said Benjamin Quinlan, CEO of consulting firm Quinlan & Associates. “While they have been able to capture loan market share with cheap balance sheet, they have been less successful transitioning that traction into the capital markets and securities space. Brand identity is a key factor here. No-one cares about the brand of a bank offering cheap funding, but they do care about who’s doing their IPO or advising th

In September 2017, the then US Federal Reserve chair Janet Yellen announced the great unwinding of the central bank’s 10-year stimulus programme. It would be as uneventful as “watching paint dry”, she said, with fingers crossed. European Central Bank president Mario Draghi followed suit in June this year, saying that he intended to reduce the monthly pace of asset purchases to €15bn until the end of December and then end purchases altogether. So what’s going to happen now? What does the new world of monetary policy, one in which two of the world’s biggest central banks aren’t pouring money into the markets, mean for the bond markets? There is no consensus on what is going to happen. There is not even consensus on what has happened, though most agree that 2018 has been a horrible year. Matt King, global head of credit products strategy at Citigroup, explained the two main schools of thought. Central banks, he said, reckon that this year has been one of bad luck. “Markets should be following the economy and the economy is in good shape,” he said, adding that central banks shrug off the flatness of the yield curve. The other school of thought is that there is too much money chasing too few assets and with the end of quantitative easing, vulnerabilities are becoming visible again. “If that is the case, the markets are leading the economy,” King said. NORMALISATION The landscape becomes a little clearer if the US and Europe are considered differently. The Fed is the furthest along. Not only has it stopped purchases of bonds, it is in the middle of the process of normalisation and of shrinking its balance sheet. Guy Miller, chief market strategist and head of macroeconomics at Zurich Insurance, believes that this both makes sense and is a reflection of a strong US economy. “It is perfectly reasonable to normalise monetary policy. The fundamentals warrant higher rates,” he said. That noted, as policy tightening takes effect, and some of the fiscal measures wear off, the economy is likely to slow in the year ahead. The wild card, or perhaps more appropriately the loose cannon, is US president Donald Trump. The wave of global QE coupled with his tax cuts have allowed US markets to shrug off his idiosyncratically antagonistic style. Indeed, there is a persuasive argument that US markets are likely to calm down next year now that Trump’s economic agenda has been constrained by losing the House of Representatives to the Democrats in the November mid-term elections. “Had Trump retained [the House], then there could have been an increase in the deficit and higher rates. He would have followed through with additional stimulus measures,” said Gordon Brown, co-head of global portfolios at Western Asset Management. EM PESSIMISM While Trump’s main focus has always been the equity markets (“Trump’s scorecard is the stock market,” is how one banker put it), global collateral damage has been felt in emerging debt markets, where costs of borrowing have rocketed in US dollar terms. The US might “only” make up 20% of global GDP, but most economies are reliant on some form or other on the US dollar. Its strength has caused problems. The impact has been most keenly felt in Turkey, Argentina and Indonesia. “EM markets are currently priced for extreme pessimism,” said Francis Scotland, director of global macro research at Brandywine Global. The tricky part is to work out how much of the bad news is now factored into bond prices. Some markets such as Argentina and Turkey clearly overshot, and as one portfolio manager makes clear: “Not all emerging markets are created equally”. All eyes are on China, not only because of its own slowdown in growth, but also because of the trade tensions that have dominated the news this year. And this is where it loops back to the US. Scotland is pragmatic about the threat

China’s role in the global economy is under intense scrutiny, thanks in no small part to the US president’s Twitter account. But while Donald Trump continues to rail against unfair competition, intellectual property theft and currency manipulation, China’s financial markets are finally opening up. “The theme of the opening up of China’s economy to the rest of the world has been talked about for decades, but the pace of change in the last 12 months has been remarkable,” said Julien Kasparian, head of securities services for Hong Kong at BNP Paribas. “Whether you look on the equities side, where we had the inclusion of China A-shares in the MSCI index, or whether you look at fixed income, where China announced a number of changes to the market infrastructure following the launch of Bond Connect during the previous year, the pace of change has been quite staggering. And more importantly for foreign investors, access to China has never been so easy,” he said. Recent changes go beyond improving access for foreign investors. In April, China’s securities regulator finally gave the green light for foreign investment banks to hold majority stakes in their securities joint ventures and lifted similar restrictions on shareholdings for fund management and life insurance companies. Regulators have finalised a trading link between Shanghai and London, and revived plans for overseas-listed companies to issue depositary receipts in China. “If you’re talking about the opening up of China’s financial sector, the real shift arguably began with the launch of the Stock Connect trading link between Shanghai and Hong Kong several years ago,” said Alexious Lee, head of China capital access at CLSA. “But whereas for the past several years the focus has been on testing the robustness of different access channels, we are now entering a different phase, which is about foreign investors stepping up their participation.” The trillion-dollar question, of course, is whether tensions with the US will lead China to change course. Will regulators target US-based banks and asset managers in retaliation for trade tariffs? Or will the chilling effect on global growth force Chinese policymakers into a more protectionist stance to defend economic growth? Most market observers are confident that China will continue to open its capital markets – gradually – even if tensions with the US escalate further. “I think it’s partly due to the foreign reserves being under pressure, so there is an incentive for the government to attract foreign investment,” said Caroline Yu, head of Greater China equities at BNP Paribas Asset Management. “But more importantly than that, China realises that increasing the participation of foreign institutional investors in its domestic capital markets is crucial to its long-term development. So I don’t expect them to shift position because of the trade tensions.” INDEX ENDORSEMENT There is plenty of US interest, too. The biggest endorsement of China’s reforms so far came from MSCI, which began adding A-shares to its benchmark emerging markets index this year. The New York-based index provider formally incorporated 226 large-cap mainland stocks with an initial weighting of 2.5% of market capitalisation in June before increasing their weighting to 5% in September. MSCI has since outlined plans to increase the weighting of A-shares in its index to 20% of their market value in two phases next year. It has also said it plans to expand the universe of stocks available in its index to include shares listed on ChiNext, China’s equivalent of Nasdaq, as well as to mid-cap A-shares, in a single phase next May. Rival index provider FTSE Russell went a step further when it announced plans to add 1,250 A-shares, comprising large, mid and small cap stocks to its main indices in three phases from June 2019 to Marc

To focus on simple issuance numbers when it comes to Green finance in 2018 would be to miss the real story. Yes, overall issuance was flat or a little down on 2017, reflecting the broader bond market environment (though European and euro currency issuance was up year-o- year, overcoming a drop in non-Green euro-denominated bond issuance). But, more to the point, 2018 saw Green finance extend its reach into new asset classes. In September alone, renewable electricity outfit Encavis launched the first Green Schuldschein (in a €50m deal), while Vasakronan, a Swedish real estate company that issued one of the first Green corporate bonds in 2013, issued the first commercial paper to comply with ICMA’s Green bond principles. The deal, in partnership with SEB, came with three tranches, amounting to SKr610m (US$67m). This followed Rabobank’s first Green CP issue, for an initial €1.2bn, in August. Christopher Kaminker, head of research, climate and sustainable finance at SEB, said: “In issuing Green commercial paper, Green finance has now moved to conquer one of the last corners of the debt capital markets.” But that is not to say Green’s innovation phase is over, according to Orith Azoulay, global head of CIB Green and sustainable hub at Natixis. “We are nowhere near done with product innovation – there are a million things we can design in the area of both financing and investment products and solutions,” she said, specifically citing Green structured finance and securitisation. Meanwhile, Belgium and Ireland added their names to the list of sovereigns that have gone Green, following France and Poland. The UK and the Netherlands are both considering issues in 2019, while Sweden has been considering the move for years but has so far refrained, citing its low borrowing requirements. LEADING THE WAY Outside the sovereign space, however, Sweden leads the way. In 2018, 14% of Swedish krona-denominated bond issuance was Green, up from 6% in 2017. In this, Sweden is an outlier. The market is still in its infancy, and the roughly US$500bn in Green bonds outstanding comprises half of one percent of the US$95trn broader bond market. The roughly 2.5% of Australian dollar issuance, and 1.25% of Canadian dollar issuance, marked as Green in 2018 is closer to the average. This leaves plenty of room for growth, and most expect the coming year to see a resurgence of Green issuance, including a lot of refis of agency and municipal Green bonds issued in 2017. The biggest driver for Green finance is the banks. BBVA issued Green senior non-preferred bonds in May (a €1bn seven-year deal) while Norway’s DNB and SpareBank issued Green covered bonds. Antonio Keglevich, head of Green bond origination at UniCredit, said: “These institutions are responding to demand from SRI investors, who want Green bonds that take a portfolio view as opposed to a project view. These deals give them exposure to a broad range of Green assets, be they loans to renewable energy or energy efficiency, or green buildings.” Execution costs remain slightly higher for Green bonds, but this has not dented interest. Increased regulatory attention on the risks around climate change, including flooding and wildfires, raises the possibility of non-green projects or issuance being penalised, for example with higher capital ratios or tax, which could equalise pricing. And while costs might be higher, “there is less execution risk with Green bonds because you have this large additional group of SRI investors,” said Keglevich. “That could be a big driver next year. Issuers that want to take execution risk off the table can do that by issuing Green bonds.” Investors have been lured into the Green market with evidence that returns are higher for Green and environmental social governance products. “Across many asset classes, the addition of a Green component creates a lower risk profile,