Five Challenges for the Business-Model “Bank”

“Banking is essential, banks are not.” This popular quote from Bill Gates from 1994 sums up the challenges the banking industry faces more than 20 years later.

There will always be a need for financial services like deposit taking, lending, and investments, as well as for processing financial transactions such as trading securities or making payments. People, however, are becoming increasingly aware that traditional banks might not be the best choice to deliver these services.

In every economy, banks have traditionally played a critical role as the intermediary between investors and borrowers. Banks contribute to economic growth by ameliorating the information problems between the two groups, by intertemporal smoothing of risks that cannot be diversified at a given time, and insuring depositors against unexpected consumption shocks.¹

Accelerating technological advances, evolving economic circumstances, and changing customer behavior have created an environment ripe for disruption of the typical business-model bank. The bad news for banks is that the pace of change is not going to slow.²

Figure 1 summarizes five key challenges that banks face now and in the near future, which will have a profound impact on their business model.

Figure 1. Five key challenges facing banks

Source: Moody's Analytics

Banks that are open to change can benefit directly from this disruption by combining their unparalleled domain expertise, reputation, and relationships with innovations in technology and a client-centric approach.

The ongoing regulatory reforms and new frameworks like Basel III aim to enhance the stability of the financial system. For financial institutions, however, these initiatives introduce significant costs and uncertainty, particularly for the largest, global systemically important banks (G-SIBs). Increases in the amount and loss-absorbency of capital will strengthen the banking sector but add to costs and hurt profitability. At the same time, new asset and funding liquidity requirements require that banks hold higher levels of liquid assets that often generate lower returns,diminishing profits even further.

Consequently, many institutions have started to pull out of some business activities because they are either non-core (e.g., commodities or structured products) or too costly for their balance sheets. In addition, financial institutions are focusing more on their home markets and a limited number of strategic markets.

To meet the new Basel III requirements, banks have to manage both sides of their balance sheets while generating sufficient returns to meet their cost of capital. The Basel III framework also introduces new costs for increased staffing, complex data analysis, and updated IT systems.³ For example, the effort by the Basel Committee on Banking Supervision to implement the principles on effective risk data aggregation and risk reporting capabilities (BCBS 239) could trigger investments of hundreds of million euros per bank.⁴

In the future, regulators globally will spin an even tighter web of rules and regulations. Banks will have to adapt their business models and – more importantly – will need to enhance their reporting processes and invest in flexible data architectures that will allow them to respond to new regulatory requirements more quickly and at a reasonable cost.

The low interest rate environment created by central banks around the world to stimulate growth following the global financial crisis will have a prolonged negative impact on banks’ businesses. Although the unusual environment is supporting borrowers’ repayment capacity and creating favorable funding conditions for banks, low interest rates will constrain the banks’ net interest margins and bottom-line profitability for some time to come.

Over the last few years, net interest margins in most regions have narrowed significantly, but funding costs have little room to fall further to offset low credit pricing. In addition, low credit demand and already high private-sector leverage in some countries are pressuring banks’ pre-provision income levels, as in the German banking market – only 6% of German banks earn their cost or capital because of their interest-dependent business model.⁵ A recent survey by the Bundesbank and the German Federal Financial Supervisory Authority (BaFin) on the profitability and resilience of German credit institutions revealed that profits are likely to fall considerably if the low-interest-rate setting persists. This is largely due to contracting margins in borrowing and deposit business, such as in the area of savings and transferable deposits.⁶

Moreover, rising compliance costs and settlement charges and persistently high credit costs in many banking systems are further pressuring banks’ bottom lines. Because of low earnings, internal capital generation remains weaker than it was pre-crisis – a particular concern as banks look to build up capital and optimize both risk-weighted and nominal leverage to meet Basel III requirements.

Banks in the euro area in particular will continue to suffer from weak profitability owing to anemic loan demand, low interest rates, and high costs. Figure 2 compares the asset-weighted net income of banks rated by Moody’s Investors Service in different regions from 2010 through June 2014, with euro area banks at the bottom of the list.⁷

Figure 2. EU banks’ profitability remains persistently low compared to global peers

Source: Moody's Analytics

The fundamental dynamics that drive client decision-making in many different industries are similar. Price, service, and trust are key – especially trust. For several years now, banks have been trying hard to regain the trust lost during the financial crisis and restore their business relationships with clients. But these attempts are meeting a client base with different needs and new behaviors. Like manufacturers or wholesalers, clients nowadays look to their banks to deliver services more quickly and conveniently, with greater transparency and much more flexibility of choice.⁸ Information about financial products and market insights were once the domain knowledge to which only banks had privileged access. Today, this information is in many cases available free of charge on internet forums or comparison portals, or in direct exchanges with experts on social media platforms. As a result, clients now expect more customized information and higher-quality advisory services from their banks than in the past.⁹

To remain competitive and profitable, banks will need to adapt to these new client needs and behaviors. One short-term strategy pursued by many banks is to cut costs by closing branches. Large and small banks in the United States – and in countries such as Germany – have been shrinking their branch networks while spending more on mobile services, in an effort to cater to changing customer behavior.¹⁰ But adapting to changing client needs is becoming an increasingly difficult task, as research shows. A three-year study in the US from Scratch, an in-house unit of Viacom, found that the expectations of those born after 1981 (the Millennials) differ radically from those of any generation before them:

• One in three is open to switching banks in the next 90 days.
• Fifty-three percent do not think their bank offers anything different from other banks.
• Thirty-three percent believe they will not need a bank at all.
• Seventy-three percent would be more excited about a new offering from Google, Amazon, Apple, Paypal, or Square than from their own nationwide banks.¹¹

New digital technologies that process information faster and facilitate communication are changing how intangible information is produced, allocated, shared, published, and consumed, which provides for more efficient processes, greater synergies, and higher productivity.

The growing spread of efficient web-based digital technologies and the rates at which people integrate these technologies into their lives have eroded some of the banks’ traditional supremacy in standardized financial products. Falling transaction costs associated with modern web technologies will continue to help consumers or third parties process information from the web and provide corresponding financial business services that compete with the banks.¹²

These financial technology start-ups (FinTech) and large technology companies such as Google or Apple have proven to be faster than banks in taking advantage of advances in digital technology to develop standard banking products (such as payment products or short-term loans) that are more user-friendly, cost less to deliver, and are optimized for digital channels. These new players also benefit because, unlike their traditional banking competitors, they are less subject to regulatory compliance and are not yet impeded by complex or costly-to-maintain legacy systems. Instead, the FinTech and large technology companies can focus on creating single-purpose solutions, designed to offer people a better experience for single products or services.¹³

FinTech are often smaller organizations, built for innovation and driven by a strong entrepreneurial spirit – and they are more in tune with the peer-to-peer (P2P) culture engendered by the explosion of social media. Consequently, the FinTech are capturing more market share every year: By 2014, the market for FinTech in the United Kingdom was already estimated to be worth £20 billion in annual revenue generated in four main segments: payment services (around £10 billion), data and analytics (around £3.8 billion), financial software (around £4.2 billion), and platforms (around £2 billion).¹⁴

Despite the segment’s impressive growth, however, the new players in the financial services space are not necessarily reinventing the banking business. They do know how to make good use of modern data analytics and web-based technologies, and in the coming years will cause major disruptions in the banking market.

Financial intermediation, or the channeling of funds from savers to borrowers, is the most fundamental role of banks in every economy. In Europe especially, commercial banks are the primary source of financing for the economy, providing more than 70% of the external financing of the non-financial corporate sector, while the financial markets (and other funding) provide less than 30%. By comparison, in the United States, commercial banks provide only 30% of funding.¹⁵

Although these numbers were stable for some time, in recent years¹⁶ the role of banks in corporate financing in Europe has declined; by the first quarter of 2014, the European banks were providing only about 55% of the funding to the corporate sector, assuming more of the characteristics of the market in the United States.

The reason for the shift is growing disintermediation – i.e., the circumventing of financial intermediaries such as banks. Owing to new regulations (such as revised capital requirements), as well as the necessary repairs and deleveraging of their balance sheets, banks – especially in continental Europe – have been unable to meet the demand for financing from the corporate sector. As a result, the amount of outstanding debt instruments issued by European non-financial corporations had grown to more than €1 trillion by November 2014, up 50% since 2009. Over the same time, bank loans to corporates declined by €55 billion to €4.28 trillion.¹⁷

Banks all over the world will need to develop strategies to respond to these challenges. The global trend toward much tighter regulation of the banking industry and the low interest rate environment are external factors that banks cannot influence. To address these issues, banks will have to adjust their businesses wherever possible. For example, they could curb or abandon certain types of businesses to avoid regulatory capital charges or adjust their asset allocations to generate additional yield.

Other challenges can be addressed more actively. Increasing quantitative supervision offers banks the opportunity to revamp their often outdated IT and data management frameworks. Newer technologies and leaner processes can help banks to not only improve operational efficiency and cut operational costs, but also make decisions faster and respond more flexibly to new developments in the market, as well as to contend with growing regulatory pressure.

With regard to clients’ changing needs and behaviors, banks have strengths they can leverage – competitive advantages that should not be underestimated. Changes in client needs and behavior can be met with banks’ expertise in the financial markets and the knowledge and management of the inherent risks, discretion handling client specific data (especially information in digital form), and many years of experience of providing clients with a high standard of operational security. The latter can be a particularly strong competitive advantage, as some of the practices of the major (international) internet firms with regard to data security are a growing concern that many people are now re-evaluating. Nevertheless, banks will need to revamp their digital infrastructures and modernize their branch networks.

To help them become part of the disruption of new digital services and not its victims, banks can address the growing competition from FinTech in different ways. The most promising strategies focus on creating and fostering a culture within their existing organization that develops new ideas and services collaborating with newly emerging competitors or investing in these businesses very early on.

Contrary to Bill Gates’ view, banks and their services are still essential to global economies. However, to fulfill their important role, banks need to critically review their business models and adjust to new realities. These realities comprise tighter, more demanding, and more data-driven regulation, profitability under prolonged pressure, new client needs and behaviors, FinTech disruption, and growing disintermediation.

To address these challenges, banks will require leaner processes, newer IT, and better data management to improve operational efficiency and cut costs. They will need to digitize their offerings to cater to new clients and find ways to become part of the disruption process instead of becoming its victims. All of these changes will require bold moves by the banks, which will pay off in the long run.