Addressing the structural challenges of European banking business models

Article by Edouard Fernandez-Bollo, Member of the Supervisory Board of the ECB, for Eurofi Magazine

25 February 2022

All business models in Europe face the same economic challenges, which requires ambitious strategies adapted to their specificities.

An essential priority of European banking supervision is to encourage all European banks to actively address the challenges they face in order to ensure the safe and sound development of their business models. Here, as in all aspects of supervision, the Single Supervisory Mechanism has a risk-based approach which takes into account the diversity of these models in a neutral way ‒ a diversity which, in itself, is welcomed for banks to meet their clients’ different needs ‒ and aims to enhance the resilience of the system overall. 

Profitability ‒ understood in very broad terms as a bank’s ability to generate each year revenues that exceed its costs ‒ fosters the safety and soundness of a financial institution, as it acts as a buffer against losses should unforeseen risks materialise. It allows banks to build up capital organically; moreover, banks with sound profitability should be able to raise capital, in whichever form, more easily. Of course, the impact which profitability might have on the soundness of an institution will depend on how it is achieved. High profitability can be a symptom of excessive risk-taking: financial risks (credit risk or market risk) and other types of risk such as those linked to suspicious activity, for example, money laundering, tax fraud, unethical selling practices or market malpractices like benchmark rate-rigging (EURIBOR). An important criterion is therefore whether or not the profits are sustainable and can be maintained over the cycle in a sufficiently secure way. 

Viewed from this prudential perspective, 2022 will be a crucial year for the way ahead to the post-pandemic new normal. Indeed, 2021 saw a recovery in profitability across business models, with the average exceeding pre-pandemic levels: after booking large precautionary impairments in 2020 on their loan portfolios, banks’ provisions diminished, and fees, commission and trading revenues increased. However, net interest income has lagged this positive development. It continued to be under pressure as margins declined further in 2020 and only partially recovered in 2021. This does not necessarily imply that banks with lending-focused business models are at a disadvantage, but merely that their income structure has been subject to more adjustment.

It should be underlined that the impact of the pandemic on profitability and business models has affected listed and cooperative institutions in similar ways: booking of provisions and impairments in 2020 and a return to lower provision flows in 2021. Moreover, the increase in fees was relatively broad-based across different business models, as various fee types increased. Asset management fees displayed the strongest growth, on the back of strong asset valuations, but transaction and account fees also increased, allowing lending-focused business models to raise their fee income. Of course, the sector in which banks are lending or risk-taking has an impact on their provisioning needs, but sound risk management helps banks to contain impairments better, whatever their legal form. 

And similar challenges remain for both listed and cooperative institutions as we have yet to see not only how the path to a sustainable recovery affects the profile of impairments and of interest income and costs, but also whether the banks’ strategies allow them to further improve their structural profitability, which continues to lag behind their international peers.

To tackle this issue, all banks should have an ambitious strategy to adapt proactively to the post-pandemic economic environment and opportunities. The ECB has long encouraged banks to make use of the opportunities given by the Single Market, but I would stress that digitalisation strategies will also be key, again across all the business models, as the pandemic has clearly increased consumer acceptance of digital offers. This will allow banks to accelerate their digitalisation initiatives, leading to a decrease in costs in the medium term, but also, and perhaps even more importantly, supporting the development of the level and nature of services called for by the transformation of the economy and, in particular, their targeted client base. 

The appropriate strategy and the corresponding levels of profitability can therefore vary according to the different nature of the clients and products in question. What is essential is that the bank’s risk profile remains well managed: from a prudential perspective, riskier assets and less stable funding structures demand higher profits to compensate for the higher risk, but this requires reinforced risk management. While it is for the institution to define its risk appetite to match its particular business model, the robustness and adequacy of a bank’s risk management governance and capabilities is an overarching principle that European banking supervision applies to all.