1998
Monetary Union - Euro may see local banks lose prized commercial business
By
Graham Lloyd
Australian Banking,
22 June 1998
Just like the millennium bomb, the advent of the euro presents Australian organisations with another enormous business challenge. However, there are few signs that we are ready to meet it. The price to be paid is missed opportunities in risk management, foreign exchange and payments, writes Graham Lloyd.
On January 1 next year, 11 countries will align into economic and monetary union (EMU). Any organisation conducting business within EMU will be dealing with:
- the world's largest developed economy (350 million people)
- the joint largest capital market (with US)
- the second largest currency bloc (after US$)
- the second largest government securities market
- potentially the world's most competitive trading environment
The euro (EUR) will be the single currency of EMU. The 11 national currencies (NCDs) plus the ECU will operate alongside it for three years until 2002. This period of 'no compulsion, no prohibition' means organisations must be prepared to accept both NCD and EUR and switch between them according to customer preference. To compete effectively, corporate Australia must also be able to comply. The problem with compliance, however, is two-fold. Firstly, we are not just 'adding another currency'; we are adding one huge one, removing 12 and for up to three years interchanging between them. Secondly, all the major issues and terms are externally-imposed. Accordingly, compliance presents a unique challenge:
- It is unrivalled in terms of breadth - every business unit and relationship in every EMU country (and many non-EMU countries) is impacted.
The depth of impact runs from the highest strategic level (what and how do we now sell and distribute?) down to operational and technical minutiae (how exactly should our MIS reflect EUR and NCD items from the same source?).
Time criticality - far worse than the Year 2000 problem. There is less than six months to assess the impact, map the response, test and implement it.
There is unprecedented uncertainty at both macro and micro levels. For instance, we cannot be certain which banks to pick because none of them have ever tackled anything on this scale, far less actually effected a euro payment through the various untried euro payment systems.
Outlay guidelines for technical compliance alone is two per cent of operating costs for Europe-based organisations - some $US300 million in many cases. Australians can expect to pay less for a variety of reasons, but could still be looking in excess of $US100 million.
The most market impacts for Australian business will be in the nature and costs of their relationships with banks.
The benefits:
- The cut in foreign exchange costs and the simplification of treasury functions will be the most visible and result in only one trading book, one liquidity and one reconciliation requirement, implying lower hedging, cash management and operational costs.
The homogenisation of payments to a common service standard where 12 exist today. This will bring new levels of competitiveness and transparency. These are already manifesting themselves in new offerings and new pricing.
Lower interest rates as the European Central Bank takes over control of monetary policy and removes the options from 'outlying' countries.
The outcome:
- The above benefits suggest a greatly reduced requirement for banking relationships. Previous infrastructure and currency differences are overridden and consequently the need for many bank relationships is simply no longer there. During the transition period to euro, corporates will need to be very clear why they would not switch to euros straight away. Consider the reasons they hold foreign currency accounts in the first place:
to manage currency flows in and out - one EUR account can do this for 12 national currencies
to hedge foreign exchange risk - there is no foreign exchange within EMU
to accumulate 'hurdle' amounts for conversion and perhaps repatriation in A$ - one EUR account will ensure funds reach the hurdle rate quicker
However, realisation of these benefits depends on the speed with which transition to the euro occurs. Most organisations will have to accept NCD payments for some time to come.
Overall, Australian corporates' challenges are those of excess choice: which banks, how to pick them and on what criteria. For instance, it will no longer be necessary to use a Spanish bank to effect payments to/from a Madrid customer. Indeed, at the extreme, the mechanisms are there for an Australian bank to manage its customers' EUR payments from Sydney or Melbourne, via direct access to one of the EUR payments systems.
In choosing and rationalising their European correspondents, Australian banks will also be overwhelmed with choice and attractive pricing. However, these are accompanied by a significant sting.
- Being the leader in say, A$-FRF holds no guarantees for the A$-EUR market. Even if it did, new levels of competition will diminish the profit dynamics dramatically.
Many European banks' contingency plans to replace lost income in European FX and payments include marketing drives into 'exotics'. These include A$, NZ$ and Asian currencies. This is Australian banks' home base. It is not large enough to sustain the envisaged increase in competition. Serious profit fallout will occur even if the current Asian crisis deters some players. Only when sufficient players depart will some form of equilibrium be restored for the survivors.
Most of the emerging payments 'bulge banks' have a powerful US$ payment offering as well. The proposition of single-point service for the world's two largest currency blocs is seductive. It would also be a short step for the user to shift all his global payments business to the single provider. This would transfer some of the pain and deploy the single provider's muscle to negotiate a better deal in, say, A$.
In the short term, Australian banks could lose direct control of corporate and correspondent relationships. Assuming the offshore provider did not set up a local A$ payment operation of its own, one Australian bank would still receive the business. It might also receive from the same source some of the business 'lost' by other local financial institutions.
However, all this business would be controlled and placed by an offshore provider with the Australian bank of its choosing. In the long term, this control could extend to dictation of service and product standards. Either way, a principal strut of customer ownership is under threat.
- This rationalisation of correspondent bank relationships is inevitable. This will force Australian banks to review the whole basis on which they are conducted. It will be impossible to give a 'reasonable' share of EUR business to most EUR players. Reciprocity is therefore unlikely to be the relationship cornerstone it was in the past. A clear, stand-alone service offering with transparent pricing is demanded. The European casualties - many old-established, warm and perfectly-satisfactory relationships - will scream. Some will retaliate, eg by cutting dealing limits. The trick is to make it quick and clean.
Banks need to satisfy themselves that rating models - theirs and those of agencies such as Moodys - are properly recalibrated to account for;
- rounding of NCD numbers into EUR
- lack of genuine historic EUR or Euroland data
- the diminution of foreign exchange and interest rate risk for a borrower's own activities
- radical changes to qualitative data such as percentage market share (reduced by virtue of the market expanding)
- amount of capital allocated against the reassessed overall risk
Many bank systems have solid links between countries, currencies and their records of public holidays. The latter are important for activities such as interest calculations and repayment dates. How vulnerable are these systems when we dismantle these links? Can they accept the concept of a single currency for 11 countries, or of one country having two currencies until 2002?
Addressing these challenges is patently not a passive strategy for any Australian corporate or bank, no matter the extent of its direct European activities. The strategic issues are of board-level magnitude. These will give rise to operational and IT challenges whose sheer scale alone demands program management skills of the highest order. These, in turn, need careful coordination with other major programs such as Y2K.
The very first and very necessary step is to raise the level of executive awareness regarding the euro and its impact. This needs to be articulated not just in individual organisational terms, but by individual line of business within an organisation.
EMU and the euro will arrive, with or without Australia's involvement. The more quantifiable the impact assessment, the more tangible the business case for the response and the greater the chance of successfully mitigating the risks and leveraging the opportunities.
Graham Lloyd is a Sydney-based Managing Consultant with PA Consulting's Finance Sector. An ex-banker, he is currently leading and co-ordinating PA's euro business in Australia, New Zealand and throughout Asia-Pacific.
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