21 September 2021

SSM's ERnria: Digital innovation in the banking sector: pay-offs and perils

In the aftermath of the great financial crisis, former Chairman of the Federal Reserve System Paul Volcker made no secret of his belief that innovation in the banking sector had brought more harm than good, famously arguing that the most important financial innovation he had seen in the past 20 years was the automated teller machine (ATM).

During the coronavirus (COVID-19) crisis, our experience has been decidedly different. Innovation in the banking sector has proved its value to society. And it is innovation much in the mould of the venerable ATM. It makes banking more convenient and time efficient. It enables completely contactless banking in times of physical distancing, and it offers bank employees the possibility to work remotely. Digitalisation is not confined to the banking industry, of course. But it has already left a strong imprint on banks, and all signs point to even more sweeping changes ahead.

In Europe, the share of consumers using digital channels and products went up from 81% to 95% as a result of the pandemic – a rise that would have taken two to three years in most industries at pre-pandemic growth rates. The banking sector, which already boasted the highest proportion of digital users in Europe, has recorded an increase of 23% in first-time digital users since the onset of COVID-19.^[1] Globally, remote digital payments shot up by about 50% when physical distancing measures were introduced, according to a sample from the Bank for International Settlements.^[2] Similarly, PayPal transactions conducted globally increased by 45% between the first quarter of 2020 and the second quarter of 2021.

The pandemic has also led to significant changes in retail payments. After the outbreak of the pandemic, the use of contactless cards roughly doubled in advanced and developing economies alike.^[3]

And there is more to come. I will argue that banks will have to adapt to changes from the outside – shifting customer preferences and competition from fintech and big tech market entrants – and on the inside, harnessing the potential of digital technologies to increase cost efficiency. If banks pass up these opportunities, their business models will become more and more vulnerable.

As I have just outlined, most people today are acquainted with online or mobile banking. Therefore, it does not seem plausible to assume that retail banking will revert to its pre-pandemic, branch-centred days once the virus is fully contained. This changed environment creates opportunities for banks to boost revenues: the customer base can increase without the need for a physical presence. New digital products and services could be offered at very low marginal cost, and pricing could be improved through advanced data use.

Digital banks can be more cost-efficient

Seizing the opportunities afforded by digitalisation is imperative for banks everywhere. But it is particularly pressing for European banks. For quite some time now, European banks overall have not been able to earn their cost of equity. Cost efficiency is one of the factors contributing to this structural underperformance. Going more digital can be an important and permanent cost-transformation strategy, as long as it is underpinned by effective internal governance and the necessary structural changes. This applies especially to banks operating in countries with dense branch networks. And while in principle it should be easier for larger banks to shoulder the costs of IT investment, there have been examples of smaller and medium-sized banks making great strides in cost-efficiency. In these cases, standardised and thus affordable digital solutions have been used, or IT development costs have been shared through cooperation.

Branch closures and staff cuts are often the most expected corollary of a more digital bank. Autonomous Research estimates^[4] that many global banks could potentially close down up to 75% of their branches, and that they are about halfway there. Cost saving from branch closures is largely down to reducing staff expenses, with direct costs of real estate playing a comparatively minor role. Some banks are lagging behind when it comes to cost reduction, having adopted a “wait-and-see” approach and placed their hopes in a long-awaited normalisation of the cycle. Others did indeed reduce branches and staff, but focused solely on cost-cutting, neglecting their income generation capacity. Their cost efficiency hasn’t structurally improved. But there are many banks that are using digitalisation for cost transformation purposes. This involves reducing operating costs while at the same time investing in staff with the necessary technological expertise and in infrastructures in order to transform banks and achieve sustainable cost efficiency.

The potential efficiency gains from digital technologies in fact go beyond trimming the branch network. They can enable banks to provide more integrated platforms, data repositories and distribution tools across their groups. There are examples of banking groups developing one single payments platform to be used worldwide. But there are also cases where non-integrated IT systems of the parent company and its subsidiaries hinder data aggregation, effective risk management and internal controls. And digitalising control functions should not only aim to cut costs, but to improve monitoring capabilities too. This is as important as the digitalisation of the front end of the business – or even more so as digitalisation leads not only to reduced costs and/or increased revenues, but also changes the bank’s risk profile, which has to be addressed.

For digitalisation to really deliver on efficiency, the digital strategy needs to be part of a wider reshaping of the business model and a streamlining of internal organisation. It comes down to the steering capacity of the bank’s management, the choice of the products offered, the legal entities maintained, the regions where the bank should focus its activities, and the ability to implement simple and integrated legal and IT infrastructures at the group level.

Digital banks could make more effective use of the Single Market

In Europe specifically, digitalisation could allow banks to make more effective use of the existing opportunities the Single Market offers. Digital solutions could enable them to rely more extensively on branches and the free provision of services, rather than subsidiaries, to develop cross-border business within the banking union and the Single Market.

Banks have so far made little use of the basic freedoms of establishment and remote provision of services that were made available with the creation of the Internal Market back in 1992, when the Second Banking Coordination Directive was transposed into national law across the then 15 Member States. So far, banks that wanted to expand their business to other Member States have done so mostly by setting up new subsidiaries or by acquiring local credit institutions and integrating them into a cross-border banking group. Choosing subsidiaries instead of branching out may have made it easier to enter a new market. This way, local expertise and knowledge of the market could be used, not to mention the advantage of brand recognition among local customers, especially for retail business. But maintaining subsidiaries also brings with it all the complications of a separate legal entity: a separate board and separate support staff, local capital and resources, separate annual accounts and treasury and finance functions and, of course, a strict application of all the local regulatory requirements on an individual entity basis.

Potential obstacles to the free provision of services across borders remain, ranging from cultural differences and different levels of financial literacy, to divergencies in national legal requirements and insufficient regulatory harmonisation at European level. However, the digital transformation process has progressed substantially in the last few years, contributing to changing consumer preferences and making them converge further. Leading technology companies outside the finance domain have shown banks how consumers worldwide can be offered uniform technology-based products and services. Fintechs and digital banks are making their customers increasingly accustomed to the use of technology in financial services. As I argued at the beginning, the pandemic is accelerating change in consumer preferences and reducing the importance of local presence. A changing business environment could allow banks to take a different approach to cross-border expansion in the near future.

The analogy that often comes to mind in this context is the experience with container shipping, which drives the integration of the global economy. It was the liberalisation of international trade that made this integration possible. But it wasn’t until the container was invented that shipping costs fell dramatically and open tollgates could be put to optimal use – estimates suggest that current trade levels would decrease by about a third without container technology.^[5] By the same token, digitalisation could boost the impetus for branching out and reaping the potential rewards of economies of scale without the need to set up subsidiaries in every Member State a bank provides services in.

ECB Banking Supervision remains neutral with respect to the specific organisational structures banks choose to adopt, including when providing cross-border banking services. We remain focused on the supervision of risks that each business model and corporate structure may entail. However, I believe we should do all that is possible, within our remit, to ensure that all avenues to growth, diversification and sustainable profit generation remain available to the banks under our supervision, as long as these avenues do not threaten prudential robustness and financial stability. This is crucial in the light of the long-lasting low profitability issue that has affected the sector for longer than a decade now, and of the transformational challenges that lie ahead....

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