2018 looks set to be the year that heralds a decade of true transformation in the banking industry. This year’s regulatory trinity of MiFID II, PSD2 and GDPR already point to a new era of data management in the EU. The most recent key reports from the European Central Bank (ECB) make clear a broader remit of priorities and the regulator’s shift in gear from prudence to sustainability.
In some way, the 2018 ECB-SSM supervisory priorities prescribe a familiar to-do list for European banks. The focus on credit risk and non-performing loans (NPLs) will continue. With the interim results of a thematic review on the introduction of IFRS 9 showing that banks could still improve their preparedness, European banks should expect to have continued monitoring on this front. Furthermore, the ECB will also be monitoring banks’ preparedness over a number of now familiar measures: the net stable funding ratio (NSFR), the leverage ratio, and the minimum requirements for own funds and eligible liabilities (MREL).
Importantly, aside from this core set of supervisory activities, regulators are articulating concerns over banks’ business and operating model appropriateness to the broader economic and digital environment. The ECB has published four supervision priorities in 2018 with “activities comprising multiple risk dimensions” introduced as a new theme. This reflects the ECB’s recognition of the greater inter-dependency between financial and non-financial risks as a threat to financial stability.
The most prominent “multi-risk” driver identified for 2018 has been the prolonged low-interest rate environment. Diverging from the gradualist tightening approach taken by the US Fed, the ECB is continuing with ultra-loose monetary policy. It seems likely that the ECB will leave rates unchanged until late 2019, with some tapering of asset purchases starting December 2018.
As we pointed out in a previous report, this prolonged period of cheap money has had its consequences. It has led to markets not pricing properly for risk. It has fed asset price inflation. Low rates have lowered the price of borrowing and contributed to an increase in debt. There has been a misallocation of resources, as forbearance has allowed zombie companies to be kept alive. The space for market correction is ample – a particular concern is a sudden reversal from the current very low levels of risk premia.
The fitness of banks’ business model to maintain profitability through the prolonged low-interest rate environment is also called into question. Already, European banks are lagging behind global peers both in current margins and in future profitability prospects (i.e. valuations). For example, more than half of Eurozone banks’ stock indices have price-to-book ratios below one, an indicator of the market’s questioning of banks’ ability to earn an RoE corresponding to their cost of equity.
To date, European banks have responded to the unfavourable environment by focusing on cost reduction, in particular through branch closures and staff reductions. Industry consolidation has also been on the rise to address the challenging business environment. So far this consolidation has been largely within domestic markets though cross-border M&As are expected to grow with the progress of European Banking Union and greater automation (and therefore standardisation) across the industry.
But as the ECB pointed out, such “expedient” options to rescue profitability are running out. In its 2018 supervisory priorities, the ECB called for a greater focus on revenue diversification, especially the growth of non-interest incomes, through the use of digital technology and capabilities.
This requires a new form of digital banking – a shift from the existing focus on streamlining customer interactions and computerising back-officer activities to the re-imagination and re-configuration of business and operating models. This will be particularly relevant in the post-PSD2 era, as incumbent banks’ monopoly over customer data and relationships dissipates.
Incumbent banks will need to take on a new set of activities. On top of the existing focus of financial intermediation, banks may need to define rules of how they engage with the ecosystem, intermediate capabilities offered on their platforms, and explore strategies to monetise proprietary IP and data. The operational model and supporting architecture – risk management included – to support this business aspiration will likely be radically different from the operating reality of today.
Whilst many activities of the banking sector have radically changed from just a few years ago, the regulatory focus on future-proofing business models will likely herald the rapid transformation many commentators predict. If the past decade of keeping key risks to prescribed levels hadn’t proved a challenge enough, European banks will be judged on more than a balance sheet in the new era of supervision. Business and operational model design will be the vantage point.
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