Economic Affairs

Brexit may prompt European banks to look East to Asia

It could be a good match: The region's vigour brings new life to moribund Europeans, while the latter's savvy with riskier products has its own attractions

In the wake of the "Brexit" vote to leave the European Union (EU), there is much uncertainty for European markets and banks. Questions are being asked about the future of London as a global financial hub and whether a migration to an alternative hub within the EU should take place.

The role of the world's largest derivatives clearing exchange, London Clearing House, is also being questioned, along with whether the European banks will continue clearing their underlying euro instruments through it.

Many issues remain uncertain, such as whether United Kingdom banks will continue enjoying the benefits of rules enabling them to sell funds and services to investors on the Continent, or whether the 360,000 EU workers in the city's banking industry will continue to get privileged work status in the UK.

In the meantime, there seems to be a surge in charm offensives by European leaders in Paris, Frankfurt and Amsterdam, all vying for the precious financial-hub title. Mr Emmanuel Macron, the French economics minister, offered to "roll the red carpet out" for UK banks considering Paris as headquarters, for example.

The problem in Europe now is that Brexit has pulled a temporary veil over the real challenges and issues that plague European banks and markets. The European banking industry is fundamentally broken, and the regulatory environment is rigid, contradictory and does not create favourable conditions for banks to thrive, no matter which city they operate in.


ST ILLUSTRATION: MANNY FRANCISCO

REGULATIONS, CAPITAL AND FEAR

In early February this year, share prices of top European banks plummeted, with Credit Suisse dropping by 43 per cent, Deutsche Bank 39 per cent, Barclays 32 per cent and UBS 29 per cent.

Media outlets blamed tumbling commodity prices, low interest rates, China's slowdown and an overall uncertain global political environment. However, the truth was far simpler. European investors had simply lost confidence in their banks' ability to meet the desired return on equity (ROE), and decided to allocate their capital elsewhere.

An ROE is a measure of a bank's ability to generate profit from every dollar of shareholder investment. Just a decade ago, these four European banks were generating ROEs in excess of 15 percent. Today, the ROE of three of those four banks are in negative territory. Only UBS is profitable.

One of the main reasons why ROEs have dropped is that European banks have been too focused in dealing with the bottom line instead of growing their top line. Most have been obsessed with cost cutting, along with reducing assets and exposures to lower-rated counterparties. Barclays, for example, shed 8,000 jobs in the first four months of this year.

Many have also taken the extreme step of cutting entire business lines that chewed up too much capital. Examples are Barclays Capital exiting prime brokerage offerings or Royal Bank of Scotland cutting its entire clearing brokerage business.

When it comes to growing their top lines, there is very little appetite for European banks to expand their market's businesses, either through launching new products or venturing into new markets. This is due in part to regulatory directives of Basel III that require banks to put aside assets or capital for expected losses that may arise from a credit- or market-related risk.

More pertinent is a culture of fear among the senior management, causing them to shy away from putting forward innovative proposals for business growth.

ENTER THE ASIAN BANKS

In contrast, Asian banks are in a prime position to expand their footprint across their growing regional markets. There are four reasons why they may have an advantage over their European counterparts.

First, Asian banks are well capitalised. Taking the example of Singapore banks, Tier 1 capital at DBS, UOB and OCBC are 13.1 per cent, 13.9 per cent and 13.8 per cent respectively - far higher than the Basel-recommended minimal level of 6 per cent. This gives banks flexibility to venture into riskier businesses such as derivatives.

Second, it is important also to look at the efficiency ratio of banks. This measures how much resources are required to make US$1 worth of revenue. For regional banks, Bank of China HK stands at 41.5 per cent, OCBC at 39.9 per cent and DBS at 44.1 per cent. By contrast, the efficiency ratio for global banks such as Citi stands at 72.6 per cent and Credit Suisse at 77.2 per cent. A low efficiency ratio for the Asian banks suggests these banks can adopt leaner models as they venture into new businesses.

Third, one has to pay attention to the Asian client base. Financial markets, including derivatives markets, are at an infancy stage in Asia. The majority of "buy-side" clients such as asset managers or corporates have little experience with complex derivatives products and rely on their bank for pricing, execution, settlement and custody. Mr Phan Thanh Son, head of markets at Techcombank in Vietnam, has said: "There is a lot of hand-holding with local corporates in helping them to understand how to use derivatives to manage their exposure."

Mr Son also noted: "Cross-border Asean trade flow is growing and is subject to a lot of conversion (currency) and interest rate risk, which gives us opportunities to sell derivatives products to regional corporates."

The important question is whether regional banks can actually place themselves strategically ahead of global banks to take advantage of a growing regional client segment willing to use financial market products. Mr Valerian Crasto , chief operating officer of DBS Treasury and Markets, says: "The advantage we have is our footprint across Asia. We understand the peculiar characteristics of each market and we are connected to the payment systems and clearing infrastructures in the region."

Dr Frederick Shen, head of business management for global treasury at OCBC, stressed that Asian clients are likely to trade market instruments with a bank they have built a relationship with: "We know our clients best. We also understand regional markets and their various regulations. In Asia, a lot of these clients are attached to one organisation that will serve all their regional needs."

GOVERNMENTS AND BANKS: FRIENDS OR FOES?

The fourth factor is the attitude of the governments or regulators. Earlier in the year when European banking stocks nose-dived, the reaction by the president of the European Central Bank, Mr Mario Draghi, was: "It's not ECB's job to protect bank profitability. It's not the ECB's job to stabilise stock markets. The central bank's job is to keep inflation in check."

Contrast this rather blunt statement with a more collaborative and supportive attitude by Singapore's Deputy Prime Minister, Mr Tharman Shanmugaratnam, who has said: "We are now embarked on our next phase of development as a financial centre. It will be driven by deeper collaboration between MAS (the Monetary Authority of Singapore) and the industry, a collective effort to leverage on new technologies, and by staking a position as a leading global centre of financial skills and expertise."

In an era of uncertainty and mistrust, investors are looking for trust, growth and stability. Brexit may have exposed Europe's fragile experiment with regional markets integration, but fixing this by shifting capital and labour within its borders will do little to help the ailing banking industry.

Asian banks, meanwhile, have a good base from which to take a dominant role in the region with strong capital bases, an organic client base and strong support from local regulators.

Both Standard Chartered Bank and HSBC are a testament to why building a banking hub in Asia does lead to a strong client franchise.

There is no reason why European banks cannot leverage their superior technology, advanced risk-management infrastructures and sophisticated product offerings to bring their presence to Asia through selective cross-border acquisition of Asian banks.

Certainly, a technology-friendly financial hub like Singapore with strong governance, English fluency, a low-tax regime and a highly educated, multicultural workforce would make a more attractive headquarters for a global bank than Frankfurt, Paris or any of the mainland European cities.

However, such a move is likely to come only after the EU has sorted out issues from Brexit and that may well take years.

Asian regional banks, for their part, will need to adopt a culture of transparency and ensure their risk practices are in compliance with global regulations but continue relying on strong support from their governments in order to operate in a business-friendly environment that promotes not only a strong culture of risk and accountability, but also one of competition and innovation.

The writer is founder and managing director of Deriv Asia, a management consultancy based in Singapore.

A version of this article appeared in the print edition of The Straits Times on July 20, 2016, with the headline 'Brexit may prompt European banks to look East to Asia'. Print Edition | Subscribe