Four themes for the future of banking

Six years after the global financial crisis, a new global environment is on the horizon.

Moderate but robust growth has resumed in the US, while China has decelerated. The stronger US economy means that the Fed will probably start a monetary tightening cycle soon, mopping up the abundant liquidity currently available to emerging economies. The lower growth in China is likely to bring the commodities boom cycle to an end. With this background, the banking industry must adapt to the additional constraints imposed on financial institutions by the new post-2008 regulatory environment.

What does a US recovery mean for the rest of the world?

The US economy has recovered from its post-2008 slowdown. It has been able to achieve moderate but robust growth rates and reduce unemployment in a sustained way. That is good news for the rest of the world, which will benefit from a growing demand for goods and services by the world’s largest economy. However, there is a flip side. With the economic recovery, the Fed has started to gradually remove the monetary stimulus and is likely to raise interest rates in the coming months. The yield on US Treasuries – so far still at historically low levels – has the potential to rise much faster than it is already priced at by the market.

If that happens, financial conditions for emerging economies will suddenly tighten. Emerging market currencies are likely to depreciate further, and their domestic interest rates – both the short- and long-end – will rise, dragging down internal demand. For those emerging markets more reliant on foreign funding, drastic balance sheet adjustments may ensue.

The end of the commodities boom

China’s economy has decelerated and is not likely to grow as fast as it did in the recent past. The deceleration is widely perceived as structural and permanent. Hence policy-makers are unwilling to introduce aggressive policies to lift growth back to the levels seen over the past decade. Instead, policy now aims to improve the quality of growth, rebalancing demand away from investment and towards consumption, and reducing the damage to the environment. In our view, demand growth from China will not support commodity prices as much as it did in the past.

The maturation of investment in natural resource sectors adds further downward pressures on commodity prices. That is particularly evident in the oil market – which over the past months has been the worst performer among the major commodities – but the prices of other key commodities such as iron ore and soy have also plunged. Even though it is still too soon for definitive conclusions, we believe the decline in commodity prices is at least partly permanent.

Commodity exporters will thus lose export income, in a permanent way. While currency depreciation may cushion the shock for those with floating exchange rate regimes, the decline in investment in the commodity producing sector is likely to have a negative impact on domestic demand. On the other hand, commodity importers will benefit – especially those running high energy import bills – and cheaper raw materials will exert downward pressure on global inflation.

Tougher global conditions

Those economies that built buffers during the good years now stand ready for a more challenging global environment. In these countries, public debt as a proportion of GDP fell significantly and its profile improved considerably: the maturity of debt increased and the share of dollar-denominated debt fell. When current accounts were in deficit, financing came mostly through foreign direct investment, and central banks accumulated international reserves, so net external indebtedness is now much lower. Finally, the adoption of floating currencies and credible inflation targets increased the resiliency of monetary policy frameworks.

Besides macroeconomic fundamentals, we also see an important role for microeconomics driving country differentiation: those economies with more business- and market-friendly frameworks are likely to be rewarded as foreign capital becomes more scarce and “selective”.

A stronger banking sector

The banking industry faces important challenges on the regulatory field in this new global environment. The additional regulations imposed on the industry after 2008 implied important constraints to the banking business in general. The impact ranged from a heterogeneous reduction of profitability affecting some business lines to activities being completely outlawed. This called for a reassessment of all lines of businesses (LoBs), with many LoBs being rethought and transformed to fit under the new set of constraints while maintaining profitability.

In this new environment, bank profits, liquidity in securities markets and the scope of the banking sector will be reduced. However, we expect the banking industry to come out of this process more resilient. It will also be more capitalized and adhere to better liquidity standards.

The coming years will bring challenges, but also opportunities for business in general, and the banking industry in particular. It is important to be prepared for volatility and risk, but also to keep eyes and minds open for new trends and good investment prospects.

Author: Roberto Egydio Setubal is Chief Executive Officer and Chairman of the Board of Directors at Itaú Unibanco. He is a Co-Chair for the World Economic Forum Annual Meeting 2015 in Davos.

He is attending our Annual Meeting 2015 in Davos, and is a panel member in the sessions, The Latin America Context, on 21/1 at 4.15pm CET and The Global Agenda 2015, 24/1 4.45pm CET.

Image: The Bank of England is seen in the City of London August 7, 2013. REUTERS/Toby Melville