Financial markets and the digital revolution
Remarks by Edouard Fernandez-Bollo, Member of the Supervisory Board of the ECB, at the Financial Regulatory Outlook Conference
Rome, 26 November 2019
As an ECB supervisor, my focus today will be on credit institutions. While this will cover only a subset of the new technology-oriented entrants to the financial markets, I am hopeful it will help us understand the impact of the digital revolution on the core banking sector.
I will begin by explaining how we at the ECB handle the flow of new fintech banks that are entering the euro area banking market.
I will then speak about our ongoing supervision of digitalisation within incumbent banks. How are these banks responding to competitive pressures? And what risks are entailed?
Licensing of new fintech banks
As the prudential banking supervisor for the euro area, we are responsible for granting banking licences. We assess the licence applications from all entities wishing to offer banking services within the euro area. To do this, we collaborate with the national competent authorities, or NCAs, who provide an initial assessment of incoming applications taking into account national law. Drawing from this initial NCA assessment, the ECB then makes decisions after also taking into account EU law.
Our guiding principle in this area is technological neutrality. It is our duty to provide a level playing field for banks across the market, irrespective of their business model or technological strategy. What counts for us is that prudential soundness is maintained, and this is what we seek to ensure when considering any licence application.
This does not mean that we analyse each and every licence application in the same way. On the contrary, we apply a proportionate approach, taking into account the bank’s size, its business model and its technological strategy.
In 2018 ECB Banking Supervision published a guide for assessing licence applications from fintech market entrants. It provides practical guidance to help NCAs assess and respond to specific fintech-related risks, which in turn helps to ensure a harmonised approach across European banking supervision when considering licence applications from fintech firms.
The guide also provides transparency to the industry, thereby helping fintech applicants to better understand the most relevant procedures and the criteria that the ECB applies when assessing licence applications.
As the competent authority for authorising all new banks in the euro area, we are in a unique position to analyse the market more broadly. As an example, we recently focused on the emergence of digital-only banks in the banking union. This analysis showed that digital-only less significant institutions, or LSIs, while still a rather small segment of the market, are expanding rapidly. Notably, many of these firms are expanding across borders, taking advantage of the Single Market to spread their digital services across a wide geographical area. On average, a retail-oriented digital LSI is authorised to operate in eleven EU countries, either via a branch or through passporting.
While digital-only banks are reasonably profitable when looked at as a group, those that are purely retail-oriented are tending to face headwinds. This may reflect that they are being squeezed both by the low interest revenues on their assets and the need to offer cheap accounts to lure in customers from established banks.
It would be premature to draw conclusions from these early developments in the market. What we have seen so far is that firms concentrating their services in particular market segments tend to generate stronger returns. This is particularly true of those focusing on payments systems.
Digital transformation within incumbent banks
While the new entrants are clearly important to the dynamics of European banking, the vast majority of activity remains concentrated within the existing incumbent banks. For us as supervisors, it is therefore essential that we keep abreast of the ongoing digitalisation processes within these incumbents.
In the current challenging profitability environment for European banks, incumbents are intensively searching for ways to reduce costs and find new sources of revenue. Digitalisation is an obvious way to achieve such efficiency gains.
On the costs side, automating manual processes could save on labour costs, and creating a sound platform for selling services online could accelerate the redundancy of expensive physical branch infrastructure. On the revenues side, banks that develop attractive and accessible digital products will gain a greater share of the new generation of tech-savvy consumers.
Incumbents are therefore investing to improve their digital offering, in some cases through internal development, and in others through investment in or partnerships with third parties.
As supervisors, we are of course supportive of banks’ efforts to become more efficient. Indeed, if banks do not invest wisely in digitalisation this may eventually cause prudential problems as traditional business models become outmoded and unsustainable.
As banks currently lack opportunities to increase the yield from their assets, reducing costs is the main available route for them to improve their profitability. In this context, it is unsurprising that consolidation is a frequently mentioned topic. In theory, mergers and acquisitions can result in economies of scale and scope, and this includes opportunities to scale up technological innovation.
The ECB approves market-driven transactions as long as prudential soundness is maintained. As part of this process, we need to weigh up the expected benefits of the merger with the risks that may arise from it. One relevant risk is the operational complexity of integrating the technological infrastructures of two banks into a single merged entity. In particular, legacy IT systems can create operational vulnerabilities during integration, so we monitor this aspect carefully.
Speaking more broadly, while digital transformation within incumbents is clearly needed, it is not a risk-free process. We supervisors need to stay fully informed of emerging technological trends and, in particular, of the risks they may entail. For this purpose, we have a multidisciplinary team of experts from across all of ECB Banking Supervision’s business areas working to develop our analysis of banks’ use of fintech.
As we continually learn about these issues, we are gradually developing guidance for supervisors that sets out expectations in each area. These findings are being developed in collaboration with the industry, drawing on our ongoing dialogue. The first big event of this dialogue took place last May, involving supervised banks, supervisors from across European banking supervision, and colleagues from authorities in the wider EU and non-EU countries. Allow me to mention a few things that have come out of this dialogue so far.
First, on the use of AI and big data for credit scoring models. We have found that, generally speaking, larger banks are more advanced in this area. Most banks are still using traditional analytical techniques alongside these new models, as there is currently insufficient trust in the reliability of AI-based systems. This approach also protects against the “black box” risk – that risk managers struggle to verify the prudential soundness of complex algorithmic decision-making. In addition, trust in the validity of alternative data remains a critical issue for banks, which pushes them to continue emphasising data from traditional sources which is still perceived as more reliable.
It makes sense for banks to take this cautious approach. As a minimum, AI models need to be tested over the course of a full credit cycle before their reliability can be rigorously assessed. While the AI and machine learning technology is promising, we are not quite ready for it to be fully rolled out.
Cloud computing is another key area of change. It can offer major benefits for firms expanding into new markets. However, banks need to take care to retain adequate control when making such efficiency improvements. They need to be aware that using the cloud can generate a risk of vendor lock-in, whereby they become excessively reliant on a single supplier – especially if they develop tailor-made cloud contracts. It is therefore extremely important that banks draft contracts with suppliers in a careful manner and ensure that they fulfil all their duties to protect customer data.
Finally, sufficient technological knowledge is crucial to enable banks to take full responsibility for successfully implementing digitalisation programmes. The right knowledge needs to permeate across banks at multiple levels – not just at the operational level but also at board level.
We are increasingly monitoring all these elements and taking them into account when developing our supervisory approach.
Allow me to briefly sum up my remarks today.
As the supervisor for banks in the euro area, we take a technologically balanced stance. As long as a business model is commercially sustainable and prudentially sound – then it is fine from our point of view.
I have explained today how following this balanced approach requires our supervisors to invest heavily in technological expertise. Indeed, the ongoing digital transformations in the market are increasingly dominating our day-to-day work. This is relevant both in our licensing work for new fintech banks, and even more so in our analysis of digital transformation among incumbents.
In order to supervise the risks in these areas, we must continually learn about the technological changes that are occurring. The best way to achieve this is through an open dialogue with the industry, so I am glad to be here today and to have the chance to participate in such relevant discussions.
Through learning together in this way, we increase our ability to ensure that innovative digital services are delivered in a prudentially sound manner.
Thank you for listening.
- See ECB Banking Supervision (2018), Guide to assessments of fintech credit institution licence applications, March. This is relevant for banks with a business model that is heavily reliant on technology-enabled innovation.
- This analysis will be published in the forthcoming 2019 Less Significant Institutions Risk Report. “Digital-only banks” refers to banks that only sell their services online and do not have a physical branch network. Many, but not all, of these banks rely on modern technological approaches to implement their business model.
- Internal analysis of digitally oriented LSIs shows that they had total assets of around €30 billion at the end of 2018. By contrast, significant institutions across the banking union accounted for €23 trillion of assets at the end of the second quarter of this year.