Preserving the diversity of European banking business models
Article by Edouard Fernandez-Bollo, Member of the Supervisory Board of the ECB, for Eurofi Magazine
7 September 2022
A business model can be defined as the sum total of systems, mechanisms and methods through which a bank generates earnings and satisfies its owners, customers and other stakeholders. The key to sustainability is to maintain an adequate cost/income ratio and keep stakeholders satisfied with the services provided. As supervisors strongly committed to a neutral and objective approach to different business models, our starting point is measuring financial resilience. From this point of view, the main parameters defining bank business models are income mix, customer mix, funding mix, size and geographical exposure. We also take other criteria into account, most importantly strategic management, risk appetite and development strategies – of which digitalisation forms a very important element. Needless to say, specificities arising from legal form and ownership structure are considered too.
Market share in the banking system can be defined in various ways. The most common indicator is total assets in terms of loans to households and non-financial corporations, but this does not necessarily tell the full story of revenues generated. Some banks specialise in certain activities only, so for them the market needs to be defined more narrowly. For example, asset managers do not aspire to have a significant balance sheet, so their market share is more adequately captured by assets under management; likewise, investment banking services are typically measured in number and value of transactions rather than any balance sheet amount. Nevertheless, most of these measures of market share taken from supervisory statistics roughly coincide. Global systemically important banks (G-SIBs) in the euro area make up nearly 50% of the total market of significant institutions directly supervised by the ECB; other universal and investment banks another 25%; diversified lenders are a bit less than 15% (even though this is the largest category by number); other bank business models (such as specialised lenders for customer finance or corporate/wholesale finance) tend to be around 5% each or below.
The degree of reliance varies – indeed it is one of the key differentiating factors among banks – but lending remains the main source of income at around 60%. This is why the latest reported statistics can be seen as relatively good; they show lending income benefiting from rising interest rates, credit demand resilient despite the macroeconomic situation and income statements not yet affected by the strong deterioration in the cost of risk. The pre-pandemic standards they are being compared against, however, are not very high.
The viability test for different business models is yet to come. The core issue is a bank’s capacity to sustain its activity through the cycle, including absorbing risks in the event of a recession. As supervisors, we believe the appropriate level of profitability should be determined bank by bank and on average through the cycle, not just at a single point in time. Everything depends on a bank’s business model and specific characteristics – the overall riskiness of the bank being the key driver when determining the appropriate level of profitability. This goes beyond simply risk on the asset side (credit risk, market risk); it also extends to liquidity risk, funding risk, interest rate risk in the banking book, operational risk and risks related to sound decision-making and strategic management and execution. The ability to retain profits through the cycle and raise capital in case of need have to be considered as well.
It is important to emphasise that supervisors do not look at the profitability of a credit institution in the abstract, but its contribution to the resilience of the banking system as a whole. This goes beyond a single-factor approach; the specificities of each case are taken into account. Even within peer groups of comparable banks, we still see very different levels of cost/income ratio, and also quite different investments in the future, in digital transformation for instance.
From the point of view of the supervisor, what is essential right now is for each bank, whatever its business model, to carefully assess the potential impact different macroeconomic scenarios could have on its customer base and prepare to respond proactively to difficulties that may emerge. Experience tells us it is best to react quickly. This includes adapting operations and services to the needs of the economy, supporting increased use of digital tools and investing to cope with emerging risks.
It is precisely because we value diversity of business models that we are sceptical about the notion that authorities are able to assess what the optimal degree of diversity is: this should be determined by the market alone. The role of the authorities is to ensure that individual banks are able to manage the risks inherent to their business model in a way that is prudent – otherwise, they should exit the market.