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Quo vadis banking?

Background

Banks now face a large number of previously unknown challenges. Apart from the fact that everyday business is becoming increasingly globalized and technologized, banking in the future will be characterized by increasingly intense regulatory provisions and a growing number of new entrants, driven by digitalization and specializing in individual aspects of the banking value stream, especially the BigTechs. All these developments will significantly change the competitive situation, value creation structures and existing business models of the banking industry.

To date, the strategic trends faced by the classical banking value creation process, which are mentioned in this book, have chiefly been innovations, which have largely been followed by banks throughout the world. It therefore seemed that the traditional value creation model of the banks had survived unchanged over the course of time. As long as the author can remember, the basic configuration of core banking industry operations, the smooth processing of payment transactions and financing operations, has remained unchanged. These core operations lay the foundations for the key functions of banking within any economy. Payment and financing transactions are simply indispensable for the proper functioning of an economy. Of course, the world has not stood still – the establishment of online banking is one example – but the basic logic of the banking industry has scarcely changed at all over the past decades.

Nevertheless, there are now signs that the perfect storm is now brewing, at least for the European banking industry. On the one hand, banks face an economic stress scenario as a result of COVID-19 in conjunction with the currently low levels of profitability of Europe’s banks. Despite the progress achieved since the financial crisis, the global financial system is vulnerable to a poor economic situation with a significant duration. Over the past few years, the share of relatively high-risk borrowers in banks’ loan portfolios has grown steadily. Impairment losses and bad debts will therefore grow even faster and more strongly in the impending global recession than would have been the case with a balanced distribution of credit risks.

This scenario is exacerbated by increasingly evident negative sideeffects of the European Central Bank’s monetary policy. Inevitably, the low interest environment that has prevailed for many years has led to investment decisions with more pronounced risk exposure than would have been the case in a normal interest rate situation at least among professional market players such as insurers, pension funds and banks who are under pressure to earn returns themselves.

Not only the economic situation, the strong growth in nonperforming loans and the poor earnings situation but also persisting cost inefficiencies and overcapacities will mean that the returns on equity of banks in the Eurozone, which are already relatively low, will face further pressure. In the event that returns on equity fall below the cost of capital for a significant period, there is a risk that the capital market will no longer be prepared to finance banks as only banks which are sustainably profitable are also stable banks. And what about supervision? International financial markets and banking regulatory authorities have already made significant preparations for this situation. Examples include the developments outlined below:

1. Through efforts including the completion of the Banking Union, the European Central Bank is attempting to establish a supervisory institution covering the entire market with a joint deposit guarantee system. The idea behind this approach is to control cross-border systemic risks especially faced by system-relevant banks via a uniform European supervisory system, the Single Supervisory Mechanism (SSM) and to avoid risk clusters which would pose hazards in the event of a financial crisis.¹

2. The German supervisory authority (Federal Financial Supervisory Authority, BaFin) already identified the hazard of cyclical systemic risks in 2019. In order to avoid excessive restrictions on the provision of loans in economic stress phases and to reduce a possible procyclical effect of the banking system on the real economy, BaFin called upon German banks to activate a countercyclical capital buffer and to raise this buffer to 0.25 percent of risk-weighted exposure to domestic loans.²

However, the regulations issued by international financial market and banking regulatory authorities have not been harmonized to date. In this context, a key challenge is regulatory arbitrage, which not only includes avoiding regulatory requirements by interpreting the scope of regulations but also the activities of the private credit funds, hedge funds and various special-purpose financing vehicles grouped together under the heading of shadow banking. These shadow banks avoid the stringent capital and liquidity requirements that apply to banks, operate outside the close monitoring of supervisory authorities and still perform functions similar to banks.³

The review initiated by the Trump administration of the Dodd Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), a key element in US banking regulation, shows how influential banking regulation can be. The Dodd-Frank Act overhauled financial regulation following the financial crisis of 2008/2009 and subjected it to stricter rules.⁴ However, the position of the Trump administration was that the Dodd-Frank Act was connected with over-regulation as lending by banks was (allegedly) restricted and the associated goal of avoiding future crises in the financial sector could only be achieved by accepting massive sacrifices in terms of economic growth. The regulatory measure as a whole was therefore regarded as too restrictive and was eased.⁵

The amendments adopted in 2018 raised the threshold at which a bank was deemed too important to fail, and was therefore subject to stricter supervision, from a balance sheet total of $50 billion to $250 billion. In addition, the rules on trading, lending and capital for banks with total assets of less than $10 billion were relaxed. An assessment of these changes would be beyond the scope of this book but it is clear that the amendment of the Dodd-Frank Act can be seen as a deregulation of US banking supervision with the political motivation of creating significantly better competitive conditions for American banks.⁶

In summary, it can be stated that the global recession as a result of the COVID-19 pandemic and the zombification of the economy pose a tremendous risk, at least for the European financial system. The dramatic economic slump and the attendant abrupt rise in risk premiums will hit the global financial system hard despite the international improvement in minimum regulatory standards and equity requirements. In the worst case, this could lead to a run on the banks and/or far-reaching market consolidation.⁷

These developments are combined with a disruption, the contours of which are becoming increasingly clear, which will call the banking sector as a whole into question. This is a change with farreaching structural consequences, the threat to the banking value stream posed by the BigTechs. Major international technology groups such as Google (USA) or Alibaba (China) are now targeting the heart of value creation in banking with their online payment services. BigTechs are increasingly gaining a foothold in the financial services market and are offering their gigantic user base more and more financial services, with the traditional banks assuming the role of service providers.

Even though the financial services business is not a core activity of the BigTechs, it is only a matter of time before a major technology company launches a scalable banking offering individualized for millions of customers in all the major banking segments with a cost base which is dramatically below the average in the sector. Customers will rapidly use the platforms of the BigTechs as a starting point for all their banking services instead of going to their traditional bank in order to purchase these services. When the direct connection with the customer is cut, some banks will become white label platforms while others will no longer be needed at all.

As yet, banks are still protected against this disruption by a) the regulations governing banking, which are rather complex, b) the extremely pronounced consumer and data protection requirements of many countries and finally c) the fact that the financial services sector is still strongly dependent on national regulatory frameworks, which pose extremely high obstacles and apparently insurmountable barriers to market entry. However, it is only a question of time before consumers, with their convenient everyday relations with the BigTechs, generate the necessary demand, especially since the customer acquisition costs of the BigTech platforms are low as a result of digitalization and big data analyses and they can relatively easily meet the banking requirements of these customers.⁸

Customers are highly familiar with and also rather trusting towards the major technology companies. As yet, severe data protection infringements, such as the disclosure by Facebook of large quantities of customer data to the data analysis company Cambridge Analytica, have not adversely affected their popularity with customers, at least not permanently.⁹ The sheer market dominance of the big technology companies must also be considered. Almost every modern mobile phone is equipped with software either from Google (Android) or from Apple (iOS). This means that almost every mobile device can be reached by Google and Apple as a platform. With the establishment of a mobile payment application and the integration of this function in their own operating systems, Apple and Google could directly target their own gigantic customer base with a banking service.

The margin pool that can be tapped by them is certainly not the decisive criterion for the development of services of this type by the BigTechs. More important for them is the fact that they would gain almost complete control over their customers’ data. Companies who are familiar with the regular payments of their customers also have information on interdependencies and contract conditions and can target these relationships in a tailor-made, individualized way. There is virtually no limit to the possibilities.

A direct consequence of this development would be a massive loss of customers by the banks; small banks would practically become superfluous,¹⁰ as the number of technology-averse customers who appreciate the vicinity of their local savings bank or cooperative bank branch will continue to fall and will become insignificant at some time in the future. There are many indications that the breakthrough of this disruption is becoming increasingly probable: Goldman Sachs is cooperating with Apple for credit card business¹¹, and Facebook has announced the introduction of a cryptocurrency (Libra) in partnership with a number of major banks and other organizations.

However, this disruption has progressed furthest in the People’s Republic of China. The leading Chinese Internet giants Alibaba and Tencent dominate Chinese payment traffic with their online payment services Alipay and WeChatPay. They play an equally leading role in product categories such as consumer credit. The main catalyst for this development is the ubiquity of mobile devices in everyday life in China. In 2018, Chinese customers already used their mobile devices for 83 percent of their payment transactions.¹² Many people no longer even carry any physical currency. In the processing of payment transactions, the Chinese market has largely bypassed the age of the credit card and moved from a cash-based economy to a digital economy dominated by mobile phones.

It is easy to predict what that could mean in specific terms for the banking sector in other economies. In China, customers now simply scan a QR code (Quick Response code) with their mobile phone in shops, hotels, restaurants and taxis, even at roadside stalls, in general everywhere where goods and services are sold in the country.¹³ It is merely a matter of time before this technology is replicated and established as a standard application, especially in view of the fact that the technology companies already provide what many customers expect, that is speed, accessibility and seamless service.¹⁴ Customers just take for granted the ethical principles of the banking business, security and reliability.

This development is reinforced by a further effect. For some time now, a small but extremely vocal group of customers and shareholders in the mature economies have been calling vehemently for companies to act with greater social and environmental responsibility. Irrespective of the fact that the significance and limits of responsible action are extremely difficult to define and possible side-effects of certain specific changes in behavior have not yet been investigated using scientific methods, this message has been further reinforced by the media and has become a significant issue on the political agenda.

Although this may seem harmless at first glance, this development may lead to self-limitation on the part of banks, which would then gradually change their image, their services and their products as well as their business model. It is true that a bank, like any other company, bears economic and social responsibility. It is also correct that the demands and expectations of the various stakeholders or society as a whole may change over the course of time. To this extent, it is legitimate for the changing expectations faced by banks to be reflected by their corporate decisions.

Nevertheless, however important topics such as climate change may be, banks face a real dilemma if these small groups in society pose quite specific demands, such as calls for banks to discontinue financing for coal-fired power plants.¹⁵ The banks which react fastest to such calls may gain a genuine edge while other banks may find it difficult to follow their example. With respect to such issues, the generation Z has become even more sensitive than the millennials were. Going forward, especially those banks which project a modern media and social profile and the implementation of socially aware business practices via good corporate communications will benefit from this development. Technology companies like Amazon, Apple, Alibaba or Google are already working intensively to earn this reputation and therefore enjoy a high degree of brand loyalty and trust throughout the world. The overall business model of the big technology companies (BigTechs) is based on communications tailored for specific target groups. For this reason, it is highly probable that small and medium-sized banks will have problems in this area compared with their new competitors.

It is difficult to predict the timing of this disruption. However, there is no doubt that banks will need to adjust to this scenario and to develop appropriate reactions as a matter of urgency. It is also clear that this development will have an impact on the economic value of banks. To put it simply, banks will probably no longer reach such high valuations. However, there is a far more serious consequence; in this context, the raison d’être of commercial banks will increasingly be called into question. The abolition of cash is being seriously discussed, which would lead to the “glass citizen” that politicians want. Crypto-currencies would no longer be exotic.¹⁶ Changed expectations of customers as regards service levels and corporate responsibility are among the developments that affect the basic monetary policy functions of banks – batch sizes and maturity and risk transformation.

It is therefore hardly surprising that the global banking industry is frantically attempting to adapt its own strategic profile to the changed conditions. This is associated with the need for continuous transformation and innovation in all facets of the sector. FinTechs, which were seen by many banks as a genuine threat for some time, have now become pacemakers for banking business thanks to their innovative power and technological openness. Although they originally set out to revolutionize banking, many FinTechs are now attempting to gain a banking license or access to such a license. They are therefore cooperating rather than competing with established banks.

Nevertheless, banking in its present form will disappear in the future. The next two years will show how correct Bill Gates was in the statement he made in 1994: Banking is necessary, banks are not. This assertion, which was probably intended to be provocative at the time, is now truer than ever before.¹⁷

Approach

This is the starting point for this book, which is divided into two parts:

The first part establishes a theoretical basis in order to make well-founded predictions for the future. The detailed presentation of banking issues in the first part of the book paves the way for the conclusions presented in the second part. The chapter The valuation of banks – a special case (Part 1) outlines the special features of valuation for banks and the main factors that have an impact as well as outlining a number of different valuation methods.

Starting from the impending far-reaching changes in banks’ strategies and business models, the chapter Banking business models (Part 1) explores the effects of strategy and regulation on the economic value of a bank. Various possibilities of making strategies clear for corporate valuations are highlighted.

The second part focuses on the assessment and context of the theoretical results obtained in the two preceding chapters. For this purpose, the chapter Strategy and competition (Part 2) investigates the attractiveness of the German banking market, which is taken as an example, and develops an opportunity/risk profile. In addition, the competitive position and structure of the two banks taken as case studies, Commerzbank and Deutsche Bank, are presented at the levels of the entire bank and of divisions.

The chapter Value creation analysis – case studies (Part 2) then analyses the relationship between the individual strategy selected by a bank and its economic value. The effects of strategy and regulation on the intensity of competition and the competitive advantage that can be gained are demonstrated on the basis of a survey conducted by the author.

Finally, the results obtained in the course of the book are summarized in the Conclusion (Part 2).