The Bank of England has issued a warning that banking sector needs to be wary of expansion as interest rates continue to increase and that resilience is vital to ensure they don’t become another high profile victim of circumstance.
Nathanaël Benjamin the bank’s executive director for Authorisations, Regulatory Technology, and International Supervision told a conference in London this week that the move to a less benign macro environment comes with huge risks.
“The first aspect of our supervisory priorities I would like to highlight concerns the global economic outlook; the relatively benign consensus that there still is in relation to that outlook; and whether there could be a breakdown in that consensus, particularly in the US,” he explained. “I am keenly aware that what happens in the US can have a far-ranging impact further afield – and I’m sure you are too. And since many international firms use the UK as their global risk management hub, I tend to worry about the impact that events in the US could have on firms’ trading businesses and counterparty risk in particular.”
Benjamin added so far, the US economy has proved resilient. Inflation is falling, though it remains elevated4. The labour market remains robust, with unemployment of 3.7%6; and output and GDP growth remain positive. And though equity indices ended the year in a steep bear market, as at time of writing the S&P 500 was up by over 10% since the year began.
“But my job is to be watchful of the risks to this consensus,” he added. “One risk, which the International Monetary Fund notes as a ‘plausible alternative scenario,’ is that credit conditions tighten significantly. But idiosyncratic events, be they natural or cyber – are never far away. And of course, while the US debt ceiling has been resolved for now, there remains plenty of scope for political uncertainty, from elections or otherwise.”
On what the new macro environment might mean for the business model of international banks, Benjamin said there were risks.
“Confidence in the viability and credibility of a bank’s business model is crucial for its clients and for the market – because once that credibility is lost, there is only so much that healthy capital and liquidity ratios can do to save you,” he said. “In a world of rising rates, clearly retail and commercial banks will tend to benefit from higher interest margins.
“However, investment banks and wholesale firms are more exposed to market volatility and broad macro-economic shocks, and do not benefit so directly from higher interest rates. For these firms, it feels that scale is becoming ever more important.
“Ever-larger players that have ever-stronger balance sheets will be able to withstand or even benefit from volatility and come out stronger on the other side. And at the same time, digitalisation will make it all the more difficult for smaller firms to achieve that scale, as technological developments make existing customers less ‘sticky’ and allow niche specialists and non-bank intermediaries to ‘salami slice’ the banking system and move individual business lines away from their traditional home and into the non-bank sector.”
Benjamin warned this kind of pressure will tend to result – as it always does – in challenged business models for banks. And there will be a temptation – as there always is – for firms to move into opportunities that are not in their DNA.
“Of course, economic dynamism, growth and competitiveness demand that banks innovate alongside the wider economy. Productive finance – banks’ ability to provide liquidity, take risk, invent new products, and establish business lines – is very important for productivity overall,” he continued. “But we know that such moves can also be a big risk management challenge, and a classic harbinger of risk management failures, when they are not sufficiently thought through or executed carefully. And no business line is without execution risk, be it prime brokerage, or consumer lending, or indeed – and in particular – crypto. So firms need to ensure that their business as it currently exists is operationally resilient before growing or changing significantly, before venturing into new products or markets. And firms should plan for such growth with open eyes and a healthy dose of scepticism about the latest fad, lest they join the annals of firms that have over-extended themselves in the pursuit of growth.”
Looking at the events of the past 18 months, the immediate aftermath of Russia’s invasion of Ukraine; nickel; the LDI episode, Silicon Valley Bank, and then Credit Suisse Benjamin said. “I find it it hard to disagree with the conclusion that Chat GPT came to when I described this speech to it, which is that ‘the greatest danger in times of turbulence is not the turbulence – it is to act with yesterday’s logic,’ – an apt quote by Peter Drucker.
“The risks that I outlined are just a few that could arise as a result of having transitioned to a less benign macro environment. Yesterday’s approaches to commodities, or matched books, or new products, simply won’t do.
“So with these examples in mind, boards and executives need to continue the list and make their own assessment of how their firm could be affected by the tectonic shift that we are experiencing. Ultimately, I think that firms with a strong clarity of purpose, sufficient regard for the lessons of the past, a healthy dose of humility, and a keen eye to the future will tend to fare the best – but only time will tell.”