Building on the diversity of European banking business models

Article by Edouard Fernandez-Bollo, Member of the Supervisory Board of the European Central Bank, for Eurofi Magazine

13 September 2023

European Central Bank (ECB) Banking Supervision has often welcomed the diversity of banking business models in the euro area as they contribute to the overall resilience of the European banking system. Nevertheless, recent events outside the European Union have shown that, at individual bank level, concentration that is not strategically and professionally managed can be a risk, with the potential to seriously destabilise not just individual banks but also groups of banks with similar business models.

For the ECB, this is a reminder that strategic steering, risk appetite and development strategies need to be adapted to specific banking models. It is crucial to have strong governance that takes due account of all the features of specific banking business models, including those related to legal form and ownership structures.

In the banking union, we have sound banks that have proved capable of ensuring that economic agents have access to financing, even in times of stress, when it is most needed. Thanks to the euro area’s diverse banking landscape, during the pandemic it was possible to avoid excluding certain groups of economic agents by meeting different financing needs. This landscape includes both large, diversified banking groups with various legal forms and geographical scopes able to draw on economies of scale and provide flexible digital solutions to reach clients of all types and local or niche players that offer tailored financing solutions to their clientele. Even now, against the backdrop of rapidly rising interest rates, we are not seeing any signs of a credit crunch driven by a lack of capacity or willingness to lend on the part of banks. Instead, there is a decrease in demand for credit. This has only been possible because euro area banks are well capitalised overall and have sound risk management and governance in place.

We should not, however, succumb to complacency. More severe economic tests are yet to come. Given the strong emphasis banking supervisors place on preventing difficulties, now would seem an appropriate time to ensure the robustness of each type of business model. Banks can use this current room for manoeuvre to invest in digital transformation, which is the future for all business models. Furthermore, they can enhance their strategic capacity to manage emerging risks, in particular environmental and cyber risks, as well as more traditional risks. The key to ensuring sustainability over the cycle is to react swiftly, before clients and counterparties find themselves in more challenging circumstances. Recent events have highlighted the importance of taking into account not only banks’ capacity to generate profits, but also their ability to achieve this in a sustainable manner. That way, banks can retain these profits and will be able to raise capital and additional funding should the need arise.

ECB Banking Supervision, with its continued focus on governance, will keep examining and challenging the way in which individual banks assess the risks they take. In particular, it will look at banks’ understanding of underlying risk drivers, exposures and early warning signs. To that end, the Supervisory Review and Evaluation Process (SREP) not only includes assessment stages in which a set of indicators is applied to all banks, but also allows the Joint Supervisory Teams significant discretion in selecting and weighting the relevant indicators based on the specific features of each bank’s business model. For benchmarking purposes, it is important to compare individual banks with relevant peers operating in similar markets and with similar income and funding mixes. We therefore take a multi-faceted approach, by applying classifications of bank business models and country exposure. This assessment is supported by flexible benchmarking tools enabling comparison with various peer groups. The SREP has long been adapted to account for specific business models through the introduction of additional targeted key risk indicators and assessment templates to ensure full proportionality, in terms of intensity and frequency, for smaller banks (less significant institutions) in Europe. Furthermore, we have pledged to embed agility and a risk-focused approach in this supervision in the long term. To do this, we have decided to introduce a new supervisory risk tolerance framework, specially designed to enable supervisors to better adjust their tools to bank-specific business models. Supervisors will thus be able to focus their efforts where they are most needed and devote more time to addressing the relevant strategic priorities and vulnerabilities for specific banks. We will therefore plan our activities based on a multi-year SREP approach, which will enable our supervisors to calibrate the intensity and frequency of their analyses more effectively, reflecting individual banks’ specific vulnerabilities as well as broader supervisory priorities.

This does not mean less supervision, but instead affords a supervisory process that is better focused and more impactful by homing in on the greatest material risks. Concentrating on the specific features of different banking business models will also give us more flexibility to tackle new and emerging risks in the context of a rapidly changing macroeconomic and interest rate environment, in effect mirroring the priorities of banks’ own governance structures.