Banking Leadership:
New Skills Required

By: Scott McDonald

From the Golden Era to the Era of Management

From the early 1990s until the early 2000s running a bank seemed easy. This was the golden era of banking. Interest rates were trending down, allowing credit to grow faster than GDP. And, for much of the period, yield curves were steep. Economies around the world grew, unemployment was low and, as a result, so were credit losses.

In this environment, it was hard not to make big money in banking. Much of the profit came from maturity transformation (borrowing short-term and lending long-term), the growth and liquefaction of the credit markets, and sticky, high-margin retail deposits. In the golden era it didn't seem to matter who ran a bank, as long as they had strong deal-making skills and the discipline to avoid over-paying for acquisitions. Exceptional management of growth and costs might lift return on equity from 16% to 20%, but 16% was pretty good in any case.

In the early 2000s the long run of interest rate declines ended, and banking became a mature business in most parts of the developed world, making it harder to grow and maintain returns. Bankers rose to the challenge: they increased the velocity of the credit business through innovative securitisation, increased leverage, were aggressive acquirers and introduced new high margin products for retail and institutional customers. But many bankers did not rise to the challenge of saying no to bad or marginal loans, pricing adequately for risk, maintaining reasonable leverage, and taking the hard decision to reduce capacity in the financial system when macro-factors required it. The illusion that managing a bank is easy was dispelled.

We know what happened in 2007, although we will spend years discussing exactly why and restructuring the foundations of the financial system so that it doesn't happen again, in the same way, soon. It would have been hard, if not impossible, to take the bold steps required to address the challenges and keep investors happy (and your share price strong) with the global economic imbalances feeding demand for hard-currency fixed income instruments, loose monetary policy at many central banks, and competitors continuing to pursue high-margin growth. But the worst excesses were avoidable.

For the immediate future, and this will probably last at least 10 years, managing a bank will require different skills. Credit will be tighter and less liquid, and rates cannot fall further; indeed, at the short end of the curve, they simply will have to rise, fl attening and perhaps inverting the yield curve. The inevitable result will be lower growth in the financial sector. In our recent work on the state of fi nancial services1, banking CEOs told us that expectations for the growth of profi ts had fallen by nearly 40% across the industry. We think it could be even worse.

Credit losses will be higher – both those coming from the structured credit assets still in the system, but also those normal credit losses driven by the recession, and which typically lag a fi nancial crisis by two to three years. Regulatory scrutiny will also be extraordinary, including the imposition of higher capital and liquidity requirements, which in combination with lower profitability is going to depress returns to shareholders across the industry. Some banks with capital to deploy – either because they avoided the worst excesses, or have found government and other sponsors to help them through – will have higher margins, driven by reduced competition and more sensible pricing of risk, to counter the general decline in industry profitability.

For investors in financial services, the new era will require careful selection of investments, rather than allowing for industry bets. The distribution of returns and valuations between banks will be stark.

You could argue that given stronger regulation of risk and capital and lower expected growth, bank management should be easier. Regulatory capital may, in the future, exceed economic capital so bankers would only need to optimise within regulatory constraints rather than defining their approach to risk and return. But it's not that simple. Regulation will evolve and be influenced by bank leaders and investors still need to understand a bank's approach to risk. The activity around new risks will once again outpace regulatory control. Bank leaders will need to start preparing for the next crisis that the new regulations will not prevent.

In this context, I offer seven suggestions for the leaders of the world's banks.

© 2009 Oliver Wyman Limited