Question

Critically discuss the key drivers of the change in bank business models. What impact did the changing business models of banks have on incentive structure?

Answer 1

The consumer banking industry is evolving quickly where traditional banking services and products will no longer be enough to retain and grow customer base while generating revenues / profits. The new competitors in the banking space are digital commerce companies like Google, Starbucks, Paypal, FaceBook, Alibaba, Amazon etc. These companies are building products and services which serve a niche need while also facilitating financial transactions. The platforms offered by these new age digital commerce companies are virtually handling all aspects of financial transactions including credit financing and advisory functions.

And there is also a new section of tech firms & startups such as Sofi, Wealthfront, Square, Motif Investing, OnDeck, Braintree etc. These financial technology firms are leveraging SMAC ( Social, Mobile, Analytics and Cloud) capabilities to capture the new generation customers and are getting involved in about every revenue-generating activity that traditional banks are engaged in. Hence, the traditional banks need to innovate around new business models which wuld be more focused on “customer engagement” and “value addition”. Every traditional bank has to re-evaluate its depth of customer engagement across the customer value chains. Secondly the measures of business success need to change from asset based measures (funds mobilized and maintained) to “value add” measures, which essentially focuses on value added across the customer engagement cycle.  

The typical retail banking business model is under pressure to transform itself into a more specialized one since they face imminent challenges such as globalization, regulation, digitalization and demographical changes.

The key drivers of the change in bank business models are as follows :-

1. Customer Behavior - The new ways of consumers getting information and living their lives are profoundly different from the earlier generation customer behavior. Increasingly, customers are looking for digital interactions that are simple yet aesthetically appealing, highly personalized and context aware so that their needs are served quickly without cumbersome intervention from the service provider. Customer Experience (CX) is now the decisive competitive differentiator between banks.

For example, corporate clients now expect their banks to provide optimised, hassle-free and digitalised processes across the full range of customer experience – e.g. account opening including KYC checks, credit applications, the set-up of cash pooling structures including associated legal documentation.

2. Macroeconomic Environment - The interest rate trends and after-effects of the financial crisis have created a tough operating environment for banks. Return on equity remains below the cost of equity. Now,banks are trying to increase profitability from product and service innovation deployed via digital channels. However, such profitability can only be achieved through efficiencies derived from requisite operational changes and process optimization.

3. Digital Innovation - Advances in digital technology are offering a variety of channels for customer interaction. Channels like online and mobile banking have already changed how customers engage with the bank. Customer interaction through digital channels is also generating valuable behavioral and transactional data. Analysis of this data enables even more meaningful ways to engage customers.
Ever since the the financial transactions have increased through digital channels, back office systems such as Core Banking and CRM will also need to be modernized to provide requisite functional capabilities.

With digitalization, there is also a shift in customer focus - from the service provider to the service, and from the financial product to the customer need. Take mortgages as an example. A customer wants to buy a house and needs a mortgage to finance the transaction. The customer's focus is on the entire experience - the property's location, its affordability, the speed of the purchase, the setup of utilities services, etc.- rather than on who provides the mortgage itself. The financial side of transactions has become less central, as customers continually seek a better experience and digitalization provides that across all activities. To stay competitive, banks are under pressure to extend their traditional financial role accordingly.

Predicting customer demand and its timing is difficult, so on-demand cloud architecture is important. Security, open source, APIs, XML and authorization protocols are other key technology considerations that are to be thought upon by the commercial banks.

4. Connnected Commerce - In the drive for global supply chains and satisfying the needs of an everconnected consumer, corporates today are keen to look at an end-to-end infrastructure. Hence, the pressure is also on banks to remain relevant to all aspects of their corporate clients’ operations. They must decide to either be the key providers of new API-connected (Application Program Interface), multi-partner corporate eco-systems, or just be an ordinary supplier of credit.

5. Market Dynamics in Cororate payments - In payments, there is a preference for instant settlement. There are country-specific schemes such as Faster Payments in the UK and the new RTP for the US, there are pan-regional instant schemes such as SCTInst across the SEPA area, SWIFT’s global instant offering SWIFT gpi. Banks should help their corporate clients to get access to instant arrangements for ‘just-in-time’ supplier payments, direct remittances, refunds, high value financial payments, payroll and staff expenses.

6. Regulation & Compliance - With legislation such as PSD2 in Europe and Open Banking in the UK, the bank’s regulators are introducing legislation to both open up banking sector to innovative new players (such as fintech companies) whilst moving the economy toward ‘instant’ settlement.

The financial crisis 2007/2008 has resulted in increasing regulatory pressure. The cost of compliance as well as non-compliance continues to rise. In many cases, streamlined customer interaction and transaction processing via digital channels helped mitigate various risks associated with regulatory compliance. Moreover, a number of compliance initiatives can generate information and context that can be channeled towards revenue creation.

7. Financial integration is another important driver of competition in the banking sector. Deregulation and liberalization have caused the banking and financial markets to become more integrated over the past few decades. In Europe, an important step toward an integrated market for financial products was the implementation of the Second Banking Directive in 1989, which introduced a “single passport” for E.U. banks. This passport grants banks located within the E.U. the right to offer services, either through the cross-border provision of services or through the establishment of branches, in any other member state without seeking authorization from the host countries. Another important step toward an integrated market was the introduction of the euro in 1999, since it made it easier to take advantage of borrowing and investment opportunities abroad as well as eliminated the currency risk in the euro area. However, financial integration has not only raised the level of competition at home, but has also made it easier for banks to expand abroad and to offset declining profits in their home markets through higher profits in foreign markets.

8. Technological advances have been an important driver of increased competition. Constantly growing cyber threats to the banking business & its customers have forced the banks to design absolutely new security features. Also disruptive technologies such as blockchain, are driving change in the industry. Blockchain can simplify the payment & transaction world. Biometrics technologies allow for seamless & secure digital authentication. Digital investment solutions such as robot advisors enable automated investment advisory services.

9. Internal Pressures - In both their retail and corporate operations, banks are under intense internal pressure to reduce operating costs and streamline internal processes to boost efficiency whilst managing risk – particularly cyber-crime. The key focus of banks is hence twofold. Firstly, on reducing the cost of transactions by removing the unnecessary friction in the end-to-end process; and secondly, on meeting the demands of instant payment schemes. Hence, digitisation has a significant role to play, as does the use of AI, Machine Learning (ML) and data analytics.

impact of the changing business models of banks on incentive structure

After the financial crisis it is particularly large, investment-oriented banks that have been under pressure to change their business models, since many business areas that guaranteed high returns pre-crisis have become unprofitable. These banks have to refocus on the core competencies and core markets in which they have comparative advantages. While maintaining their focus on corporate and investment banking, they will also need to be more active in retail banking to better diversify their income structure and to meet regulatory requirements.

For smaller, more retail-oriented banks, to become more profitable and stable, they should increase their share of non-interest income by cross-selling additional services or products to their customers. It should be noted, however, that this does not imply that retail banks should expand into investment banking and other areas in which they have little experience since this might make them more risky. Small, retail-oriented banks and large, investment-oriented banks, therefore, differ in how they have to restructure their business models. This implies that better-diversified banks are able to generate higher risk-adjusted returns and are more stable. However, it may also increase the level of systemic risk in the banking sector if banks diversify their activities in a similar way. Hence, from a financial stability perspective, it is necessary to have both diversified as well as specialized banks.

Many banks are now undergoing merger & acquistitions, This will particularly affect small banks. Due to growing competition in lending and deposit markets, they are under pressure to increase their cost efficiency as well. One strategy is to merge with other institutions and to increase scale. A larger size may not only allow them to generate economies of scale, but also help smaller banks to better diversify. Smaller banks, even though they tend to grow in size with changing business models, will remain focused on more personalized, high-value-added products, such as small business loans and personalized investment and trust services, with profit margins driven by the willingness of customers to pay higher prices for these services. Relationship banking thus provides a niche for small banks that many large banks are less capable of providing.

Banks’ business models have changed considerably over the time. Banks have transformed from just engaging only in traditional commercial banking activities to becoming active in non-traditional activities, such as investment banking and proprietary trading. While this has created new opportunities for banks to generate profits, it has also made banks more complex and exposed them to greater income fluctuations. It became more evident during the 2007/2008 financial crisis, which primarily affected large, investment-oriented banks. Due to these banks’ size and systemic importance, the recently introduced Basel III banking regulations are intended mainly at reducing their riskiness. These regulations include higher capital and liquidity requirements, both of which will reduce banks’ profitability, since their ability to make profits depends much on the extent to which they can leverage their balance sheet and engage in short-term funding. Growth will also be limited by higher liquidity requirements, which reduce the extent to which banks can fund their activities by wholesale funds and make customer deposits a more important source of funding.

The growth of financial markets has also increased competition in traditional lending and deposit markets, forcing banks to look for non-traditional sources of income to make up for the shortfall. The growth of insurance products and mutual funds, for instance, has allowed banks to earn commission income on sales of these products. A number of banks have also set up their own asset management companies in order to generate additional revenues from fund management. Some banks have also started underwriting debt and equity issues, as well as issuing derivatives, and trading securities on their own account on the secondary markets. As a result, banks nowadays offer a much larger range of products and services and activities off-balance sheet.