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Technology exposes banks’ vulnerabilities

Speech by Pentti Hakkarainen, Member of the Supervisory Board of the ECB, at the Institute of International Finance Digital Interchange: The Global Dialogue on Digital Finance

Frankfurt am Main, 16 September 2020

Reaping the benefits of information technology (IT) is not a new challenge for the banking industry. As a bank CEO in the 90s, I saw giant leaps made in technology. Owing to the severe economic crisis at the time, Nordic banks had no choice but to innovate and make use of technology to become more efficient.

It is therefore no surprise to me that European banks were technologically ready to handle the coronavirus (COVID-19) crisis. They have continued to deliver banking services smoothly throughout this challenging period, showing that their IT systems were up to the job of keeping the show on the road.

However, operational resilience alone will not be enough for banks to survive and thrive in the coming decades. We are seeing profound long-term technological changes that will alter the way customers demand and receive financial products. Some of the expected unbundling of traditional services is already occurring, and the potential exists for powerful new competitors to enter the market.

In the light of these circumstances, banks must pursue ambitious digital transformation plans. Customers’ demands for convenience require banks to have global state-of-the-art technological service models. Merely adopting advanced technologies to improve internal processes is not enough. Satisfying the needs of sophisticated customers in today’s increasingly competitive environment will require innovation to place the focus on the customer service experience.

Challenging times for banks

COVID-19 has put operational resilience to the test

The COVID-19 crisis has challenged the digital capabilities of banks under European supervision, both in terms of their interactions with customers and their internal operations. At the height of the lockdown in late March, around 60% of the staff of large European banks were working remotely and more than 20% of branches were closed. For the time being, banks envisage only a gradual return to the office ‑ on average, 40% of bank employees are currently still working from home and around 5% of branches remain closed.

So far, banks’ IT infrastructures have stood up well to this test. In particular, almost all banks have managed to continue providing services to their customers during these extraordinary times. Similarly, in the face of heightened cyber risks during this period, banks have not suffered any major setbacks to their operational resilience.

This shows that they have done their job in adopting the technology needed to run their businesses digitally.

Stiff competition affects profitability prospects

Despite this demonstration of technological resilience during the pandemic, banks continue to face difficulties in achieving profitability levels consistent with their cost of equity. There are long-term structural reasons for this relating to prevalent overcapacities in banking and low cost efficiency in the sector.

Indicators for the euro area show signs of overcapacity first and foremost in terms of the overblown physical banking infrastructure.[1] When we compare the euro area banking sector with its global peers[2], we can see that there is overcapacity, particularly in terms of high bank branch to population ratios and low ratios of bank assets per bank employee.

A similar picture emerges when we look at the number of euro area banks. Concentration ratios measure the competitiveness of markets by aggregating the market shares of the top five firms in a specific market. While there is variation across countries, on aggregate the concentration ratios of the euro area banking sector are significantly lower than the global average. This is a sign that many banks are chasing relatively few customers across our continent.

A banking system operating with significant overcapacity is liable to become unhealthy. On average, euro area banks have low net interest margins and low returns on assets. This allows them to cover variable costs, but is not enough to achieve sustainable profitability over the business cycle.

One feature of the prevailing competitive environment is that most euro area banks do not enjoy much in the way of pricing power. This is seen in falling bank loan-deposit margins that have been observed in many euro area countries in recent years. Similarly, the ECB has recently observed that loan pricing is not particularly responsive to worsening or improving estimated future credit losses.

Unsurprisingly, when combined with the immediate challenges of the pandemic, these long-term structural dynamics result in a gloomy profitability outlook. The aggregate return on equity (RoE) of euro area significant institutions declined in 2019 to less than 5.5%. In the first quarter of 2020, the annualised RoE fell further to an aggregate level of 1.2%, although according to our projections it is expected to stabilise at an average of 1.4% by the end of the year.

Strategic questions – defend or attack?

Faced with this pressure to be profitable, banks’ leaders face many difficult decisions as they seek to craft sustainable business models. One important element they must take into account is their digitalisation strategy, both in terms of its timing and how ambitious they want it to be.

In this regard, banks are adjusting their digitalisation strategies in different ways in response to the pandemic.

On the one hand, around 20% of euro area significant institutions have accelerated their strategic plans for IT innovation and digitalisation. This shows that in many cases, the prevailing circumstances are acting as a catalyst to help bring about needed changes to service delivery. The pandemic has enhanced the need for agility in terms of remote working and in delivering digital services, and has provided an opportunity to accelerate technological change. In addition, approximately 50% of large European banks that have drafted plans for IT innovation and digital transformation have not changed course and in the main have proceeded as planned, despite the pandemic.

In other cases, the uncertainty banks are facing from the impact of COVID-19 has led to more defensive technological responses. As a result of the pandemic, 30% of euro area significant institutions intend to postpone their plans for IT innovation and digitalisation.

Transformation of the banking sector

To put these longer-term strategic questions in the right context, we need to think about how the sector will evolve over the coming decades. One important trend that is here to stay and will affect banking sector profitability is the tendency for customers to unbundle their consumption of banking services as a result of technological developments.

Digitalisation has spurred new market practices that encourage traditional banking businesses to be split into their constituent parts, such as the provision of payment services, lending and deposit-taking. These services are offered by new market players, including both digital banks that focus on providing a platform, and non-bank entrants. This unbundling of banking and other financial services enables new players to enter consolidated markets while putting pressure on incumbents.

Fintech firms enter financial markets by offering payment, peer-to-peer lending or crowdfunding services to underserved clients and younger, more tech-savvy customers. By unbundling traditional financial services and focusing on single activities in the value chain, fintechs introduce new business models and build on their distinct comparative advantages.

They may establish and promote themselves as pure online service providers, harvest new sources of data, and employ artificial intelligence, including machine learning and other methods, to offer financial products tailored to client preferences. Unlike incumbent banks, fintech-oriented banks and other fintech companies are not usually burdened by legacy IT systems.

Fintech firms may also re-bundle financial activities. They use user-friendly online or mobile phone applications in conjunction with other innovative channels to provide financial investment services, access to crowdfunding platforms, or instant comparisons of financial services.

New ways of providing financial services brings the prospect of bigtech firms entering the market. The scale and customer base enjoyed by large non-financial corporates provides them with significant potential to generate profits by delivering services en masse in an efficient manner. Bigtech firms may venture into combining online retail platforms with payment services, i.e. non-financial with financial businesses, to facilitate market exchanges with their customers. The handling of payments also makes it possible to offer clients investment opportunities through financial market entities such as money market funds.

These developments create some challenges for supervisors. Under the current regulatory framework, different entities which to a certain extent could perform similar activities, such as credit institutions, e-money institutions and payment institutions, are subject to various regulatory and supervisory frameworks, either at national or European level. However, some fintech firms that provide specific financial services may not fall under any regulation.

In view of these developments, sectoral and entity-based supervision is faced with the challenge of ensuring effective and intrusive supervision and oversight of activities partially within and partially outside the regulatory scope. As the trend towards unbundling is accelerated by innovation and digitalisation, the current framework may need to be reviewed to ensure a level playing field and to maintain the principle of “same activity, same risks, same supervision and regulation”.[3] Should bigtech companies decide to enter the financial services market on a large scale, particularly the retail market, we must ensure that the associated risks are appropriately identified and addressed by the regulatory framework.

Irrespective of these transitional challenges, my overall view is that the ongoing process of technological transformation across the financial sector will clearly be positive for customers and also for banks.

Richer data and innovative analytical tools will help banks better meet the needs of their customers. Digitalisation will allow banks to reduce operating costs, which in turn will allow firms and individuals to access banking services at lower prices and from the convenience of their own homes. Over time, these trends will improve the performance of the banking sector in its core task of efficiently allocating capital across the economy.

Aiming for global state-of-the-art technology

Against this background, to survive over the long term, banks must fight to remain relevant.

Today’s tech-savvycustomers can easily compare services online and choose those they find most convenient. These customers will not choose inferior, cumbersome or expensive products. Such products will therefore not survive in the market, and neither will the banks that offer them.

Not all banks will succeed in grappling with these challenges. Intense existing competition along with technological and structural trends that will broaden the market will naturally lead to some market exits in the years ahead.

Supervisors understand that it is the job of banks alone to decide on their corporate strategies, including their digitalisation goals. However, when contemplating the future, I feel that it is increasingly unlikely that banks will be able to run profitable long-term businesses based on second-class IT systems. Only global state-of-the-art technology will be enough to successfully meet the demands of today’s customers given current and future competitive market pressures.

As banks pursue digital transformation, supervisors are involved to ensure that changes are implemented in a way that is consistent with the prudential soundness of supervised banks.

For this purpose we proactively engage with banks to gain knowledge of their transformation processes and take-up of innovative technological solutions. In our dialogue with banks, we look not only at their innovation strategies and human and financial resources allocated, but also at more specific issues.

For example, banks should be ready to update and even replace their legacy IT systems to ensure they are resilient enough to withstand heavy reliance on remote working and provision of services. Continually conducting short-term fixes of legacy IT systems is not a sustainable strategy in the long term. Supervisors also look to ensure that robust cybersecurity procedures are in place.

As they pursue digitalisation, banks must avoid becoming too dependent on certain technology and IT infrastructure providers, including cloud services. Outsourcing arrangements and contracts with third-party providers must have clear terms and conditions and enable banks to monitor the performance of their providers at all times, as well as ensure the protection of their customers’ data.


To conclude, let me reiterate my main points.

The coronavirus crisis has demonstrated that euro area banks already benefit from operationally resilient technological systems. Banks have not struggled to continue providing services throughout the crisis. These crisis conditions have thereby revealed how much of banks’ business is already being done via digital means.

However, without sustainable profitability levels, the euro area banking market will likely face some consolidation and market exits.

This digitalisation-related disruption is unavoidable, and overall it should be welcomed, given that it will improve service standards and the efficiency of banks’ activities.

Within this competitive context, second-best IT systems are unlikely to be good enough. Only global state-of-the-art technologies will satisfy today’s sophisticated customers.

Thank you for listening.

  1. See Gardó, S. and Klaus, B. (2019), “Overcapacities in banking: measurements, trends and determinants”, Occasional Paper Series, No 236, ECB; and Desislava, Andreeva, Maciej Grodzicki, Csaba Móré and Alessio Reghezza (2019), “Euro area bank profitability: where can consolidation help?”, ECB Financial Stability Review, November, Special Feature A.
  2. In more technical terms, the z-score comparison.
  3. ESCB/European banking supervision response to the European Commission’s public consultation on a new digital finance strategy for Europe/FinTech action plan

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