The bank business model in the post-Covid-19 world
The Covid-19 pandemic has induced a deep global economic crisis. While so far banks have shown their resilience, partly thanks to major reforms after the crisis of 2007-2009, the crisis will put them under stress. Moreover, the traditional banking model was already being challenged pre-Covid by three trends: persistently low interest rates, enhanced regulation, and increased competition from shadow banks and digital entrants. This column introduces the second report in the Future of Banking series from the IESE Business School and CEPR, which provides a perspective on how the current crisis and these trends will shape the future of the banking sector.
The world is witnessing a large and synchronised economic crisis. Forecasts for 2020 suggest a drop in global GDP of 6% with a record number of countries growing at negative rates (OECD 2020). Advanced economies will suffer a much larger drop in GDP, of a size not seen since the Great Depression. No doubt, banks will come under stress as large-scale insolvencies among firms will arise and a wave of bankruptcies among households may follow. In addition, while banks entered the crisis better capitalised and more liquid, the size of the crisis will likely strain them to a degree exceeding that envisioned in many stress tests conducted so far (ECB 2020).
The crisis comes on top of the combination over the past decade of several trends that have meant increased competitive pressure on banks and that, in particular in some regions, have lowered their profitability. In the second report in CEPR/IESE series on The Future of Banking (Claessens et al. 2020), we argue that the global pandemic is likely to prolong, if not accelerate, many of these trends – digitalisation in particular. While the economic crisis has triggered policy responses to stimulate lending to the real economy while assuring the stability of the banking sector that provides breathing space in the short run, deep restructuring of many banking systems will be needed in the medium-term.
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Low interest rates, regulation and the bank business model
We have now been living in a world of low interest rates and subdued growth rates for more than a decade. These persistently low rates have negatively affected bank profitability through reduced net interest margins and weakened monitoring incentives and lending standards, in particular for those institutions more reliant on maturity transformation and net interest income. In the wake of the 2007-2009 financial crisis, we also witnessed over this period an increase in prudential requirements, regulatory scrutiny and compliance costs, as analysed in the first report in this series (Bolton et al. 2019). These policy steps have contributed to a more resilient banking sector, which is very beneficial in the current context. At the same time, however, the tighter rules have lessened banks’ competitiveness relative to shadow banks and added to a migration of some business activities away from the banking sector towards shadow banks. Moreover, stricter regulation has put pressure on banks’ profitability.
Figure 1 Bank profitability remains low in Europe and Japan (price-to-book ratio)
Note: Monthly averages of daily data.
Sources: Datastream; BIS calculations.
The Covid-19 crisis most likely means interest rates will remain low for much longer. Although in the short run banks are bound to benefit from being the channel of liquidity support and having access to central bank support, the deep crisis hitting the real economy is likely to bring a new surge in non-performing loans and could threaten banks’ solvency once again.
Digital money, FinTech, BigTech and banks
An additional development during the pre-Covid world was the massive application of digital technologies and the emergence of new competitors. While these have allowed for many new products and services and helped improve the efficiency of incumbent banks, they have also favoured the entry of new firms, increasing competition with traditional bank business models.
The impact of technology on bank business models has been profound (Vives 2019). Technological advances have affected payment systems, capital markets activities, credit extension and deposit collection. In the report, we analyse in detail the area where much activity is happening – namely, digital money and payments. For decades, banks have controlled digital forms of money and payments through regulatory protection of deposits, exclusive access to the central bank settlement system and close partnerships with credit card companies. The challenge today comes from a variety of digital assets that do not sit on the balance sheet of banks: cryptocurrencies, electronic wallets, stablecoins, or balances with a telecom provider. The competitive advantage of the new entrants is not based on the asset itself, but on the payment technology associated with it. The convenience of payments and the connections to other parts of the growing digital life of consumers and business alike, accelerated by the Covid crisis, has been the key to success. The dominance in payments of tech companies in China or mobile telecom providers in parts of Africa are examples of the extent of disruption.
Disruption from technology has happened in many other areas, not just payments. Entry in the different financial service segments has come from new types of providers: ‘FinTech’ and ‘BigTech’. FinTech providers of credit are more present when the country’s general development is higher and its banking system is less competitive, but less so when the country’s regulation is stricter. Non-bank entry is not yet meaningful in demand deposit-like taking activities, possible due to concerns about regulatory burdens. BigTech platforms, with their advanced technology and especially their (associated) greater access to (big) data, could make major inroads, but have not done so to date.
The entry of new players greatly affects banks through downward pressures on fees and prices and more compressed margins. Banks have responded, but many argue that they are far from adopting technology effectively themselves. As a result, their profitability comes further under threat.
The technological advances and new entry require regulatory responses. The technologies used by the new entrants can create new risks, including fresh consumer and investor protection issues, as the accumulating evidence on risk of discrimination associated with greater use of technology and big data shows. Since more entities now provide financial services and in new forms, it is also crucial to ensure a level playing field. A related important question is where to draw the regulatory ‘perimeter’, given that the overall industrial organisation of the various financial services markets is changing. The technology-induced changes also call for reassessments of competition and data policies.
The post-Covid world
In the short run, banks may enjoy a revitalisation as they continue lending to their customers during the crisis, notably as soft information can more valuable today than hard information. They also enjoy the protection of the safety net and access to deposit financing.
Nevertheless, Covid-19 will likely accelerate the digitalisation and the shift over the medium term of activities away from the sector. Medium-sized banks will likely be suffering the most since reaping cost efficiencies with large IT investments, crucial in a persistently low interest environment, will be out of reach. As a result, the banking sector will need deep restructuring; winding up banks and consolidating the remaining ones will be preferred. Whether in the post-Covid-19 world, political obstacles to cross-border mergers will prevent, as states become more protective of their national banking champions, is a major policy question.
BigTech companies have many of the ingredients to get ahead in the post-Covid world. They are digital natives; they have the technology, customer base and brand recognition, as well as vast amounts of data and deep pockets. Banking may thus move from the traditional oligopoly to a system with a few dominant platforms that control access to a fragmented customer base, with a few BigTech firms, together with some platform-transformed incumbents, monopolising the interface with customers. In this scenario, ensuring customer data ownership and portability for individuals, and data interoperability between platforms, will be key to keeping switching costs for customers low and the market sufficiently competitive.
Digital disruption poses a formidable challenge to regulators, which must adapt by balancing facilitating competition and allowing the benefits of innovation to pervade the system with protecting financial stability. In order to so, regulators must coordinate prudential regulation and competition policy so that compliance does not becomes a barrier to entry while at the same time entry does not becomes destabilising. Competition can be fostered by light regulation of the entrants, but at the potential cost of decreasing the profitability of incumbents and thus increasing their risk-taking incentives. In addition, this may mean the generation of systemic risks to non-bank entities.
The current crisis will test the resilience of the financial system and the regulatory reforms implemented after the global financial crisis of 2007-2009, which were examined in the first report from the Banking Initiative. In particular, it will stretch the limits of central bank intervention, and put to the test the incomplete Banking Union in the euro area.
Bolton, P, S Cecchetti, J P Danthine and X Vives (2019), Sound at Last? Assessing a Decade of Financial Regulation, The Future of Banking 1, CEPR Press.
Carletti, E, S Claessens, A Fatas and X Vives (2020), The Bank Business Model in the post-Covid-19 World, The Future of Banking 2, CEPR Press
ECB (2020), Financial Stability Report, May.
OECD (2020), Economic Outlook, June.
Vives, X (2019), “Digital Disruption in Banking”, Annual Review of Financial Economics 11(1): 243–272.