CRUNCH TIME FOR UK BANKS AS THE INDUSTRY SHIFTS FOCUS FROM CLEANING-UP THE PAST TOWARDS SUSTAINABLE GROWTH, SAYS KPMG REPORT

• Banks significantly reduced lending by over £364bn in the past five years; opening-up the loans market to shadow banking initiatives
• Banks must focus on increasing the return on equity to above their cost of capital by embedding stronger cultures, ethics and new technologies
• Window of opportunity for banking industry as performance in the UK economy makes way for growth and profitability

UK banking is at a crossroads as the industry finally shifts its focus from cleaning-up the past and begins making steps towards delivering sustainable growth and profitability, according to a KPMG report which analyses the mid-year results of the UK’s five largest banks.

Headline figures show a continued return to profitability since the second half of 2013, with a combined profit before tax of £15.2bn secured in the first half of 2014, a gain of £18.3bn. The 2014 benchmark also revealed that in the past five years, overall loans and advances have reduced significantly by £364.7bn or 14% to £2,334bn in the first half of 2014, with customer lending accounting for £309.0bn of the decrease.

KPMG’s report, ‘Bank to the Future’, highlights that banks will continue to face a challenging environment, with the unprecedented pace of technological innovation, shadow banking initiatives and legacy infrastructure hampering long-term growth. However there are also significant opportunities to make step changes to deliver sustainable growth.  The report suggests that if banks are to boost their return on equity to above their cost of capital, they must embed strong cultures and ethics and new digital technologies.

Richard McCarthy, UK head of banking at KPMG said, “Our report shows that banks are now at an inflection point. The vital next step is to look forward to generate real business growth, as opposed to driving with the rear-view mirror.

“We have to remember that banking requires risk-taking. Yet in the rush to clean-up the past, both banks and regulators have lost sight of this. The reduction in lending to customers since 2009 is testament to this risk aversion. We are however seeing bank leadership teams beginning to take positive steps to seize the opportunity to achieve sustainable growth and this is encouraging.

“Governments, politicians, regulators and commentators need to recognise progress and help banks refocus towards growth. The punishment of the banking industry as a whole, as opposed to individuals, will hinder the banks’ return to growth and their ability to increase lending.”

“Bank leadership teams recognise the need to create strong cultures, systems and behaviours that will lead to better outcomes for their customers and society as a whole.  However, while the tone at the top is very clear, the challenge is embedding changes throughout the organisation.”

The report also revealed the profound impact the huge cost of customer remediation has had on the banks’ return on equity, with returns reduced by £31bn as a result of remediation since 2011.

However the latest results indicate some easing as the year-on-year remediation charge has reduced by 44% to £2.4bn. This was reflected in the marginal recovery in the first half of 2014, as a 6.8% return on equity was achieved from its record low of 6.5% at the end of 2013.

However, the return on equity still needs to rise above the real cost of capital, which currently stands at 12%.

Richard explained, “Interestingly, if we took away the impact of the huge cost of customer remediation since 2011, the return on equity would have been significantly higher over the same period. Lower margins, massive conduct-related costs and much higher capital requirements have all contributed to a lower return in the sector in recent years. This has reduced the much-needed resources banks require to re-focus their strategies on growth.

“Boosting returns remains hard due to low interest rates and higher capital. However there is light at the end of the tunnel on remediation costs and impairment charges as these continue to fall. Provided the economy continues to improve and regulators support the banking industry, banks are in a good position where they can start to build their business for the future.”

Bill Michael, EMA head of financial services at KPMG added, “The future is there for the taking and there is certainly room for optimism, especially given the performance of the UK economy.

“Shadow banking initiatives are increasingly penetrating under-served areas of the market. These initiatives are creating a challenging environment that traditional banks are unfamiliar with. Equally, if banks get to grip with technology quickly, there is a unique opportunity for banks to capitalise upon. While competitors entering the market do not have the same legacy-based obstacles preventing them from pursing new opportunities, banks can offer the scale, reach and experience many players cannot.”