Banking on change: Lessons from the UK

  • By Tim Johnston

It will only be a matter of time before unprecedented change in the UK banking sector market will reach Australia’s shores, writes Nikko AM’s Tim Johnston 

The seemingly endless turmoil around Brexit has led many to conclude that the UK economy is struggling, with obvious implications for the banking sector. 

So, what learnings could Australia apply to the domestic market, and how will this impact the composition of the banking sector over time? 

On a recent trip to the UK, it became clear that the economy is surprisingly strong, which appears contrary to negative sentiment expressed in equity market prices. 

While it wouldn’t be surprising to see consumers and businesses behaving cautiously, recent retail spending growth of 5.2 per cent and a rebound in business investment in the March quarter indicates that consumers and business are shrugging off the uncertainty. 

The confidence may stem from the lowest unemployment rate in 40 years at 3.8 per cent and resulting wage growth of 3.4 per cent. 

Until the most recent spike in Brexit noise following Theresa May’s resignation as Prime Minister, most economists were expecting two interest rate increases in the next 12 months. 

With labour markets tight, the significant pent up demand in housing combined with strengthening business investment could see the UK economy accelerate sharply should some resolution of Brexit be achieved. 

In discussions with key participants on the banking sector, it became clear that while the market remains more price competitive than it was 12 months ago, the level of competition has recently stabilised and there are signs of potential improvement. 

Two of the major players have attempted to take market pricing higher and although the industry did not follow, there are three factors that will be supportive of higher prices in the medium term, including:

1. The excess liquidity created by ring-fencing is forecast to be absorbed over the next 12 months;

2. Changes to asset risk weights will result in lower returns on equity, in the absence of price increases; and 

3. The second-tier banks have looming funding pressures resulting from the need to repay the funding provided by the Bank of England Term Funding Scheme. 

However, with the current competitive back drop, an issue gaining increasing attention is the potential for technology to significantly reduce operating costs. Clearly similar benefits will be available in Australia. 

Technology is set to drive significant change in the banking sector in the next decade, in particular, having profound implications for employment levels in the financial services sector, with flow-on impacts on the broader economy. 

These developments will ultimately benefit consumers in the long-term but over the short-term, could also see significantly fewer people employed in the banking sector; banks expanding into other areas where they can commoditise services; and implications for borrowing capacity.

Essentially, technological advances will reduce the cost of delivering banking services so significantly over the next decade that there is reason to believe that we are close to realising peak revenues for the banking sector. 

Competitive pressures will ensure that these cost benefits are passed through to consumers and, as a result, net interest margins and lending spreads will continue to compress while still preserving bank profitability. 

While cost reductions are a long-standing feature of the banking sector and have facilitated net interest margin (NIM) reduction, the extent of potential cost savings in the next decade has some interesting and profound consequences. 


The banking sector is likely to employ far fewer people in ten years than it does currently. Given the significance of the major banks in Sydney and Melbourne employment markets, reductions of staff numbers by up to two-thirds would have ramifications for the demand for office space and unemployment rates, with flow through effects on house prices. 

• New technology could potentially facilitate a significant reduction in staffing. One major international bank executive recounted a conversation with his head of operations who laid out a feasible scenario where headcount in their operations team is reduced by approximately two- thirds over the next five to ten years; 

• Know your customer requirements currently require a staff of 8,000 people at one institution. The introduction of artificial intelligence will reduce this enormously; and 

• A shift to paperless mortgages is reducing costs dramatically, with cost-to-income less than 20 per cent compared to industry averages percentages in the low 40s. 

Additional services

Banks are seeking to provide value-add services, and this has implications for other sectors. 

The UK banks spoke of their intention and ability to provide a range of additional consumer services relatively cheaply. Most at risk appear to be commoditised consumer services such as insurance and electricity. The ability of banks to utilise data and artificial intelligence to identify potential cost savings for their customers will reduce or eliminate the ability of providers of confusing but ultimately commodity services to extract excess returns. 

Lower costs

The significant cost elimination will likely result in ongoing NIM reductions and thereby lower borrowing costs for consumers. Estimates suggest that a 40 per cent reduction in operating costs in consumer lending could see a nine per cent reduction in lending rates. This will have implications for borrowing capacity and asset prices. 

Unprecedented change is sweeping through the UK’s banking sector, and it’s a matter of when – not if – a comparable level of change will reach Australian shores.

Tim Johnston is a portfolio manager with Nikko AM

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