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by Anthony Harrington

Amongst all the speculation that is swirling around concerning the fate and future of many large European and U.S. banks, at least one thing is certain, according to management consultants McKinsey. Looking across the global banking sector as a whole, McKinsey analyzed what banks need to make in order to cover their current cost of equity, while also matching up to the additional capital requirements that are required under Basel III.

According to McKinsey, the Basel III capital requirements are going to require banks to find an additional $1.5 trillion in capital, and if you add that to their current cost of equity, you wind up with a very big gap between what banks are earning, by way of profits, and what they need to find to recapitalize. The only way for the global banking industry to get back onto a sound footing is going to be for them to find ways of cutting costs drastically while also increasing their returns, the consultancy argues.

In the words of McKinsey director, Stefano Visalli, as quoted by Jamie Dunkley in an excellent article in The Telegraph on 19 September:

“This return gap is enormous. It is bigger than the total profits of the global pharmaceutical and automotives industries put together. To achieve this [the required increase in profits] will require a radical break with past trends for an industry that has never before decreased costs in absolute terms; in the next years it may need to reduce them by 15 percent to 25 percent, as well as increasing revenues.”

Compounding the issue

On top of this, the global banking sector is starting to be impacted by the West to East shift in the global economy and this is going to accelerate steeply going forward. According to McKinsey, by 2020 emerging market banks are likely to increase their share of global banking revenues from a third to around 50 percent. That is going to squeeze big banks in advanced markets through a period when they need to double their profits to close the returns gap.

While the long-term future position as sketched out by McKinsey looks, ahem, challenging, the immediate position is no less so. European banks are struggling to find dollar funding, which has pushed the Federal Reserve into agreeing to reinstate dollar swap lines with the European Central Bank (ECB), so that it can make emergency dollar loans to European banks who need to refinance their U.S. assets. The ratings agency Moody’s downgraded three U.S. banks, including the mammoth Bank of America (BAC), which has $2 trillion in assets but is in woeful shape with massive exposure to the U.S. housing slump. It followed this up by downgrading some of the largest French banks on the grounds of their exposure to sovereign debt risk. All of this is like the tolling of a warning bell signalling to passing ships that dangerous reefs lie close at hand.

Neither the ratings agencies nor the markets are particularly thrilled with the current “prudential” regulations that allow banks to pretend that market movements in European sovereign debt do not have to be figured into their solvency calculations. As things stand, sovereign bonds are held to be backed by governments, all of whom can be relied on to meet their obligations as far as the interest and principal on their debts are concerned. Even Greece. And Ireland. And Portugal. No risk there at all. Not, at least, as far as banking regulations are concerned. Should we be worried? Of course we should…

Disclosure: No positions

Source: Are Bank Bailouts Inevitable?