x Abu Dhabi, UAEMonday 22 January 2018

Opportunity springs from financial crisis

The entire landscape of the global banking industry has been altered since the onset of the downturn five years ago. But within the clouds there is a silver lining.

Banks in the US and Europe are adapting to a new regulatory environment, which includes divesting illiquid assets such as property loans. Mark Ralston / AFP
Banks in the US and Europe are adapting to a new regulatory environment, which includes divesting illiquid assets such as property loans. Mark Ralston / AFP

The wave of banking and capital market reforms introduced following the financial crisis is creating fundamental changes in the global banking industry.

With new regulations such as Basel III stipulating higher capital requirements for certain portfolios, banks have been forced to revisit their business models. Many are faced with the tough choice of raising more capital against some of their assets or reducing their balance sheets by selling non-core or non-profitable assets.

The potential impact of these new regulations on global banking is far-reaching. Banks across the world, especially in the United States and Europe, are investing considerable resources in adapting their capital structure to the new regulatory environment. Many are resorting to downsizing business lines that, because of the new rules, are a strain on profitability.

The continuing challenging global economic environment has added to these pressures. Sovereign debt crises in Europe and relentless market volatility have affected the ability of banks to access capital and generate returns while minimising risks. Combined with the new capital rules, these challenges are exacerbating the trend among banks to shed non-core or non-profitable assets.

The IMF estimates between this year and next, European banking assets will be reduced from between US$2.2 trillion (Dh8.08tn) and $3.8tn. Already, over the past few years, many banks have sold a substantial amount of liquid assets such as bonds and loans. Inevitably, the next step is the sale of illiquid assets through securitisation or outright sale. On the debt side, illiquid assets that could be sold include infrastructure loans, commercial and property loans, shipping loans, small and medium enterprise loans or long-dated project finance; on the equity side, stakes in illiquid or private companies, property assets and proprietary trading activities.

Notably, not all assets being sold are distressed. Many are simply assets that cannot generate sufficient return on capital because of new liquidity and capital requirements.

The need for banks to sell non-profitable assets has created significant opportunities for investors who do not have the same regulatory and capital constraints.

Investors today have the opportunity to acquire these banking assets at attractive prices. "Capital relief trades" are a major investment theme for capital providers globally.

Pension funds, insurance companies, hedge funds and private equity funds, which are natural players in this area, are taking advantage of such opportunities. Although mark-to-market issues, appropriate provisioning and price expectations stand in the way of an optimal buyer-seller equilibrium, the capital relief trade market is expanding rapidly. Many investors have already set up dedicated "regulatory capital funds" or sectoral funds to tap these growth opportunities.

While the estimates of capital relief trades across assets classes over the next few years are already substantial, business opportunities emerging from this shift are expected to continue even beyond the time frame of deleveraging programmes. As more banks withdraw from certain business lines, investors such as private equity and hedge funds - part of what is often called the "shadow banking system" - will increasingly step in to fill the gap and grow their direct lending activities, enhancing their role in financing the real economy.

In this context, Middle East investors including sovereign wealth funds (SWFs), large family offices and ultra high net-worth individuals (Uhnwis), who have already emerged as major providers of capital to the global market, can play an even more important role in the growth of this new market.

They could do this in two ways.

In the short term, they could make direct acquisitions of attractive investment portfolios from banks, either in partnership with specialised funds or on a stand-alone basis.

In a low-yield environment, some long-dated illiquid assets provide particularly attractive yield opportunities and a compelling risk-return profile. Examples include infrastructure assets such as trains, ports, airports, energy leases and real assets; securitisation of diversified portfolios of corporate debt and property loans; trade finance and shipping loans; and distressed credit.

In the longer term, rather than being only financial investors in such portfolios, Middle East investors can drive strategic efforts to establish and seed funds and companies dedicated to the acquisition, management and growth of such investments.

The emergence of these opportunities could provide significant positive spin-offs to regional financial centres in the Middle East looking to grow their global platform. Growing interest among Middle East investors to acquire global banking assets could attract specialist funds that can benefit from being closer to capital providers in the region, leading to greater growth and sophistication in the locally based asset management industry and the expansion of the talent pool.

In conclusion, despite the challenging economic environment five years after the financial crisis, the shift in the global banking business model is bringing new investment opportunities for a range of players. Middle Eastern investors such as SWFs, family offices and ultra high net-worth individuals, have an opportunity to play a vital role in providing capital to the global market as well as in attracting global asset managers to support the growth of the regional financial centres.

Adel Afiouni is the managing director of the investment banking division and the head of global securities for the Middle East and North Africa at Credit Suisse