economc crisis ship on storm-tossed sea

The 10 years that have passed since the end of the global financial crisis were marked by extensive regulatory reform and the rebuilding of the financial system. Now, with the momentum for global reform dissipating and economic growth weakening, much of the global financial services industry looks shaky once again.

In the autumn of 2009, the G20 launched a sweeping reform effort that aimed to address the major failings of the financial services system that were exposed by the crisis. Those failings include the precarious position of many large financial services institutions (which were found to lack capital and liquidity during the crisis); the fact that many firms were deemed too big, or too important, to fail; and the lack of oversight in derivatives markets and the shadow-banking sector.

In mid-October, the Financial Stability Board (FSB), a Switzerland-based international body that monitors the global financial system, released its latest report on the status of the G20 reforms and the current condition of the financial services industry. That report acknowledges that while many of the G20’s initiatives have been adopted, there are areas in which policy-makers have missed deadlines and progress has stalled.

The effort to improve the quantity and quality of the capital held by the world’s big banks is one area in which policy- makers have largely succeeded. They’ve also developed a process for identifying banks that probably are too big to fail. And additional capital and regulatory requirements have been imposed on those banks.

However, in other areas, such as reforms to banks’ leverage and funding requirements, the FSB report states, those reforms are behind schedule. The adoption of the final capital adequacy requirements (slated for 2022) remains at an early stage in some jurisdictions – creating an uneven playing field between the countries on track to meet the global deadlines and the laggards.

Similarly, there is bumpy progress on some of the added requirements for firms deemed too big to fail, including resolution planning intended to specify how large firms can fail and be wound up without resorting to bailouts by taxpayers.

“More work is needed to address operational capabilities and execution aspects of bank resolution strategies,” the FSB report states.

Similarly, regarding derivatives-market reform, the FSB report states that aspects such as mandatory trade reporting have been widely adopted, but progress in margin requirements and central clearing is less advanced.

There’s also work to be done in making securities trade reporting truly useful. While many jurisdictions, including Canada, have implemented trade reporting requirements, the absence of global data standards means regulators probably still don’t have a comprehensive picture of derivatives exposures, as envisioned by the G20’s original reform efforts.

Similarly, efforts to monitor risk and improve resilience in the shadow-banking sector (unregulated or underregulated non-bank entities that perform some financial services) remain a work in progress, the FSB report indicates.

Yet, while the G20 reforms are far from complete, the FSB report states, the measures put in place since the crisis have proven to be an “important driver of change in the global financial system.”

For example, the FSB report states, the world’s big banks have more than doubled their capital positions since 2009 and leverage has dropped by half over the same period. Liquidity positions also have improved.

However, overall bank profits remain below pre-crisis levels, leaving many banks vulnerable in the event of an economic downturn.

According to a recent report from McKinsey & Co., more than half of the world’s banks are generating returns that are lower than their cost of equity: “A majority of banks globally may not be economically viable.”

Not only have bank profits generally been weaker since the crisis, the McKinsey report adds, the banking sector appears to be in the late stages of its current growth cycle.

“As the recovery from the global financial crisis completes its 10th year, the signs of decelerating growth across the world are unmistakable,” states the McKinsey report.

Those signs include the fact that global bank assets grew at their weakest rate in five years in 2018, and that asset growth trailed GDP growth by about 150 basis points. In addition, banks’ margins have been shrinking over the past five years, even in markets in which interest rates rose (such as Canada and the U.S.). Loan impairments remain historically low, the McKinsey report adds, indicating little room for improving balance sheets.

While there have been economic ups and downs over the past 10 years, “this time, the breadth and depth of the slowdown signal that we have entered the final stages of the economic cycle,” the McKinsey report states, noting that the global banking sector’s returns on equity have remained flat since 2013.

As a result, bank valuations declined by 15%-20% in 2018, the McKinsey report states, adding that earnings forecasts for the next couple of years have dimmed.

At the same time, the McKinsey report states, competition has ramped up, with fintechs and big tech firms increasingly targeting the traditional banks’ better-performing segments. The report warns that while banks’ capital positions may have improved since the crisis, new liquidity risks could be lurking.

For example, the McKinsey report states, banks may face new threats to liquidity because customers increasingly can withdraw their funds online. The rise of social media increases the risk of runs on bank deposits fuelled by online chatter, whether it’s accurate or not.

In this environment, the McKinsey report argues, there’s no time to waste. For many of the world’s banks, the time remaining until the next downturn represents their last chance to secure their survival.

“Reinvent, scale, differentiate or perish,” the McKinsey report states. “These are the stark choices banks face today. With late-cycle clouds gathering, the call for action is loud and clear.”