Business models under the scope – ECB’s supervisory focus in 2016

Business models under the scope

The ECB’s top priority for 2016 is making sure banks’ business models are sustainable

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The supervisory review and evaluation process (SREP) sets out the second pillar of the three pillar Basel supervisory standard. According to SREP the supervisory authorities need to obtain a full picture of a bank’s circumstances and risks and take appropriate actions.

In the past, SREP was less harmonized in single EU member states, but this has changed as a result of guidance from the EBA and the single supervisory mechanism.

The European SREP consists of four core elements: business model analysis, analysis of governance and controls in place, and a bank’s capitalization and liquidity.

Lessons from the financial crisis

At first glance, it may seem surprising that business models form a supervisory focus, since it actually is the most fundamental task of management to ensure the profitability of a bank. But we only need to look to the recent financial crisis when failing banks were rescued with public funds and supervisors were criticized around the world. One of the reasons for the crisis is that some banks had (and still have) unsustainable business models; which is why sustainable business models and profitability are among the ECB’s priorities for 2016, along with governance and IT topics.

Analyzing business models is a complex situation for the ECB. The profitability of European banks is on average lower than the profitability of banks in other economic areas, driven by the combination of low interest rates, high competition and the focus on long lasting interest-induced earnings. The high level of credit risks and of non-performing loans in some Eurozone countries cause additional burden on the profitability of banks. In this scenario banks could be tempered to lower their covenants and collateral standards in order to increase their turnover. Banks are further burdened by the high costs related to updating technical infrastructure, and new regulatory requirements put pressure on the profitability of banks. Taken together, this limits the possibility of internal capital increase of a bank, thereby reducing the robustness of the banking system.

ECB-Review from A to Z

The ECB has already started its analysis of business models of banks with a number of qualitative and quantitative retrievals. The “desk-top-analysis” is deepened and completed by supervisory onsite-reviews. In the reviews the ECB is analyzing the business model of a bank using a top-down approach: looking at the strategic set up including future activities, target markets, clients, products and value and cost drivers. The review also includes the processes established to create a strategy. In a bottom-up analysis the ECB compares the results of the top-down analysis with the activities of the front office function, target definitions and target results of the client advisors and the development of new products or new markets. It is critical that the bottom-up and top-down results of the reviews are in line.

ECB could encourage banks to exit the market

The ECB has legal power to ask banks with a weak business model to implement specific requirements, e.g. to require the stop of a certain business. The ECB also has the power to assess whether a bank is failing or likely to fail - this would be done in conjunction with the Single Resolution Board (SRB), in effect as of January 1, 2016. A negative decision by the ECB would inevitably lead to a bank resolution scenario.

In practice, the aforementioned bank resolutions will occur in extremely rare cases. It is more likely that weaknesses in the business model of a bank will trigger a capital add-on than a bank resolution. As we saw in the last SREP (2015) the average Pillar 2 capital add-ons had been set to approximately 10 %: twice the pillar 1 minimum. From a regulator’s perspective this reaction is legitimate given that weaknesses in business models contributed to the financial crisis. The ECB’s actions on capital add-ons are comparable with an improved crumple zone of a car – improving the buffer for unexpected losses.

From the perspective of the affected banks, capital add-ons increase the fundamental problem: a bank with a weak business model will have difficulty delivering a return on equity at least equal to its cost of capital. Higher capital requirements will reduce profit on capital employed and make it more difficult for that bank to find new investors. It is possible that a capital add-on may trigger (indirectly) market exits or accelerate a consolidation of the banking sector. This situation is not likely to change in the near future as we see additional initiatives from regulators. For instance, “life time expected loss provisioning” according to IFRS 9, new capital requirements from standardized approaches regarding credit, market and operational risks, new methods for capital requirements for interest rate risk in the banking book and limitation of capital relief from internal models (“floors”) are only going in one direction.  These initiatives will further increase banks’ capital requirements.

A careful support of the reviews serves business success

In order to be best prepared for the regulatory reviews of the ECB, banks should document their business model in a consistent and convincing fashion. This includes persuasive inferring of the strategy from an analysis of market conditions, competitors, clients, products, regulatory and technical trends and anticipated trends. A transition of the strategy into the financial planning should also be prepared. This financial plan should be consistent and reconcilable to risk related topics like risk planning, risk appetite and limit systems. Additionally, a bank should ensure that these top-down analyses fit defined targets, products and clients from the selected market segment.

Over the medium term it is advisable to deal intensively with regulatory requirements and their impact on capital position. Only in this way will it be possible to realize which business activities will not generate positive value contribution and to take appropriate countermeasures. It is unavoidable to increase the quality of data. For instance: In contrast to the production industry it is very difficult for a bank to break down value- and cost contribution to clients, products, regions, etc. Increased quality of data allows banks to receive more economic impulses, not only to comply with regulatory requirements (like BCBS 239 risk data aggregation and risk reporting). 

In the long run, banks have to answer the question of whether their business model is sustainable. In the past, banks used a high leverage of the capital employed and complexity of products and structures, but now and in the future, both factors will be limited by regulations (higher capital ratios, leverage ratios, recovery and resolution legislation, consumer protection rules, etc.). There will be new competition from so-called Challenger Banks and the like that are becoming increasingly more viable in an increasingly digital society.

No one yet has the answer to the strategic question of what will banks look like in 20 years.

Source: Boersen-Zeitung, 30th January, 2016

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