The last few years have seen a growing interest in analyzing the business models of financial institutions from all angles: regulators and supervisors show concern about the viability and sustainability of financial institutions, financial institutions review their own business models, and the academic world is giving more and more attention to this matter. While this was already a matter of concern in all these areas (see Llewellyn (1999)), it was the various collapses caused by the financial crisis that spurred interest in this topic.
This is currently in addition to the unprecedented transformation that financial institutions are experiencing in their business models: profitability is threatened by interest rates, macroeconomic uncertainty and the entry of new competitors; regulation, partly as a result of the financial crisis, makes increasingly demanding requirements in all areas of banking activity; and todays’ more sophisticated technology and savvier customers are putting a big question mark on banks’ traditional way of doing business.
In more detail, some of the main factors defining the environment in which financial institutions have been operating in recent years are:
All this puts increasing pressure on profitability, mainly as a result of lower interest rates. According to the Fed, banks' financial margins have declined by more than 100 bps since 2000, 70 of them in the last 5 years, both for assets (narrower margin on loans, but also on securities and other assets) and for liabilities (regulatory requirements on the financing structure and reluctance to applying negative rates to deposits, making it difficult to take advantage of the low interest rate environment).
To some extent, this landscape has come about as a result of the financial crisis that started in 2007, which has significantly reduced bank profitability: ROE levels, which were often above 15% before the crisis, are now close to the cost of capital (often even below it) in the economies with the highest banking penetration levels.
As a result, there is explicit concern on the part of entities, regulators and supervisors about the insufficiency of these ROE levels to meet costs. In the words of Danièle Nouy: “The return on equity realised by banks in the euro area is still well below their costs of equity”.
This concern about profitability does not have an obvious solution: banks try a combination of cost reduction, both in the more traditional approach (branches, sizing) and in a more disruptive one (digitization), with revenue increases (pricing, fees and commissions).
In this context, business model analysis (BMA) is all the more relevant and, within it, so is business risk or strategic risk management, defined as: “The current or prospective risk to earnings and capital arising from changes in the business environment and from adverse business decisions, improper implementation of decisions or lack of responsiveness to changes in the business environment”.
Business risk, thus understood, is receiving considerable attention from regulators and supervisors:
Moreover, there is increasing concern about the potentially systemic nature of business risk, since: “Low profitability is obviously a major concern for the stockholders of banks. And it is also a concern for supervisors. Over the long term, low profitability threatens the ability of banks to generate capital and access financial markets. Ultimately, a lack of profitability affects the stability of banks.”
Against this backdrop, this paper aims to provide a detailed and comprehensive view of the supervisors’ analysis of the business model. The document is structured in three sections with three objectives:
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