Gertrude Tumpel-Gugerell: Business models in banking - is there a best
practice?
Speech by Ms Gertrude Tumpel-Gugerell, Member of the Executive Board of the European
Central Bank, at the CAREFIN Conference on "Business Models in Banking: Is There a Best
Practice", Bocconi University, Milan, 21 September 2009.
* * *
Ladies and Gentlemen,1
It is a real pleasure for me to speak today at Bocconi University. Founded in 1902, Bocconi
was the first Italian university to offer degrees in economics. As one of the oldest economics
departments in Europe, Bocconi leads the way in intellectual thinking on economic progress
and innovation. It therefore seems the perfect place to host today's conference on banking
business models and to discuss their future.
Given that the worst financial storm since the 1930s is only gradually calming down, the topic
chosen for this conference is very apt. Banks have taken centre stage in the ongoing
financial and economic crisis, and any definitive resolution to the crisis essentially hinges on
banks regaining financial health and public confidence on the basis of sustainable and
welfare-enhancing business models.
However, not all banks have been equally affected by the crisis, nor have they been equally
responsible for it. The main players have mostly been large international investment banks or
banks that had moved away from traditional retail banking activities. This movement towards
a presumably more "modern" business model relied principally on the origination, distribution
and trading of often complex securities, on other fee-income generating activities, as well as
on a funding structure more dependent on wholesale markets.
Many factors have contributed to the current financial crisis, namely excessive risk-taking,
the emergence of a shadow banking system, the exponential growth of innovative financial
products, inadequate corporate governance incentive structures at banks, the lack of proper
regulation and an environment of abundant liquidity at low interest rates. But my speech
today is going to focus on excessive risk-taking and banks' creation of innovative financial
products, which has led to the transformation of their business models.
To a large extent, this shift towards a new business model was based on innovation in the
structured credit market, particularly in respect of securitisation instruments, such as credit
default swaps, asset-backed securities and collateral debt obligations. A common feature of
all these financial innovations is that they transform, transfer and trade credit risk. One of the
main consequences of the use of such instruments is that large amounts of credit that were
previously predominantly illiquid (such as bank loans) then became liquid and could
potentially be traded in financial markets.
However, we must not blame such credit risk transfer instruments and vehicles per se . I am
confident that those instruments generating real economic value will survive the crisis, albeit
probably at much reduced volumes, in less complex structures, with improved transparency,
and subject to financial regulation and supervisory structures. They will survive because,
when prudently applied and sufficiently monitored in terms of their impact on financial
stability, financial innovations generally tend to make a financial system more efficient
without necessarily increasing its fragility.
At this point, it is worth asking what the main banking business models could or should look
like from a policy-maker's perspective, which takes into account implications for both
financial efficiency and stability. I will limit the remainder of my speech to a few of the main
points of the argument and will also point out some early lessons to be learnt from the crisis.
What is so special about the business of banking?
I will start with a standard definition of a "bank", recalling the main functions that banks are
supposed to perform and explaining why these functions are so important and special that
they warrant relatively close public intervention and oversight.
A bank is "an institution whose current operations consist in granting loans and receiving
deposits from the public".2 This definition refers to the core activity of commercial banks,
namely the simultaneous acceptance of deposits and offering of loans, which distinguishes
them from other financial intermediaries. However, banks typically conduct a broader range
of activities, which can be subsumed under the following three functions:3
•
First, banks provide the public with liquidity (money) and payment services through
their deposit-taking business.
•
Second, banks transform assets in terms of denomination, quality and maturity, as
well as manage the associated risks.
•
Third, banks process information and monitor borrowers using specialised
technologies. In so doing, they often establish long-term relationships with their
clients, which may further mitigate the negative impacts of adverse selection and
moral hazard on the resource allocation process.
Changes in banking business models
Before I turn to the question of how this traditional banking model has changed over the past
few years, I am going to take a brief look at financial market history.
Glass-Steagall: investment banks versus commercial banks
Looking specifically at the history of the financial markets in the United States, it was bad
banking practices and the public outcry after the stock market crash of 1929 that brought
about the Glass-Steagall Act of 1933. Interestingly, the Act followed an enquiry into whether
commercial banks had sold unsound securities to their customers, thus converting potential
bad loans into securities issues. The Act therefore prohibited commercial banks from
underwriting, holding or dealing in corporate securities, either directly or through securities
affiliates.4 In my view, the concerns that prompted the Act were very similar to those
currently being voiced - particularly in relation to concerns about banks' business models
and the sale of unsound securities to unsuspecting investors.
The Act had a global impact on competitive conditions. For instance, the large presence of
major US investment banks in Europe can be traced back to the implementation of this Act,
which separated investment banks from commercial banks. The Act also had an impact on
the supervision of banks, mostly in the United States, but also in other regions in the world,
including Europe. Owing to the funding structure of commercial banks and the stronger links
between them - and hence their importance for financial stability - commercial banks were
regulated accordingly. In contrast, investment banks were expected to be in less need of
close monitoring and regulation, as they were seen to be less important from a financial
stability perspective. The current crisis has vividly illustrated how the actions of not only
commercial banks and investment banks, but also other financial players, can have a major
impact on all parts of the financial system and the economy at large.
I should now like to focus on two major factors that have changed the way banks do
business. First, I will discuss the changes in banks' business models that relate to the
sources of their revenue. And, second, I will focus on the changes in the funding of banks
and talk about the unintended consequences of the expansion of their securitisation
activities.
Diversification in the sources of revenue
With regard to the change in the sources of banks' revenue, the repeal of the Glass-Steagall
Act in 1999 is a prime example of deregulation in relation to banks' business models. If we
compare the regulations in place today with those of 20 years ago, we see an unprecedented
process of deregulation across regions and financial sectors. One consequence of this
deregulation has been a global trend towards more diversification in banks' income sources,
i.e. towards higher brokerage fees and commission - more generally called "non-interest
income". The increase in non-interest income provides banks with additional sources of
revenue and can therefore provide a diversification in their overall income. At the same time,
non-interest income has usually been a much more volatile source of revenue than interest
rate income. Investment banks, for example, have a high dependence on non-interest
income. Typically, they are more profitable than traditional commercial banks, but they are
also much more leveraged and their earnings are more volatile (see Chart 1). The volatility
of earnings, combined with the close ties of investment banks to other financial players, calls
for a higher level of monitoring for these systemically important players.5
Chart 1: Bank profits and volatility of earnings
(median values of return on equity and standard deviation from 2000 to 2007)
Source: Bankscope.
In addition, there is one problem relating to the banks' risk management that applies mostly
to investment banks, but also to other large financial institutions: most risk management
techniques neglected the correlations of risks across securities, as not just banks, but also
rating agencies, did not sufficiently internalise the growing systemic, market and liquidity
risks. Moreover, banks underestimated tail risk. The existing risk-management techniques
worked well at predicting small day-to-day losses in the middle of the distribution but failed to
anticipate severe losses that are much rarer. But clearly, it is exactly those severe losses that
matter most. This mispricing of risk relates to deficiencies in risk management techniques,
but also, and perhaps more importantly, to existing incentives in the banking system oriented
towards the short term profitability of banks.
Diversification in the sources of funding
Turning now to the second factor, the change in banks' funding sources: at the same time as
the change in the sources of banks' revenue, there has been a wider change relating to
banks' liability side of the balance sheet.6 In particular, this refers to the shift in banks'
business models away from the traditional model of financing. In the traditional model, there
was a heavy reliance on retail deposits, but this has been replaced by an increasing reliance
on market-based sources of funding. The significant recourse to specific funding instruments,
such as mortgage bonds and securitisation, has made banks increasingly dependent on
capital markets, but at the same time, of course, less dependent on deposits, to expand their
loan base. This is evident from both an upward trending total assets to deposits ratio of the
largest euro area banks and an increase in the loans to deposit ratio of large
(see Chart 2.a)
EU banks (see Chart 2.b). To the extent that more stable retail deposit financing has been
replaced by wholesale funding, banks may have become more exposed to market dynamics
and perceptions, constituting a potential source of instability in the banking sector.7
Chart 2.a: Total assets to total deposits of the largest euro area bank
(outstanding amounts, eonia banks)
Source: Bankscope.
Chart 2.b:Loans to deposit ratio of large EU banks
(corrected for extreme outliers)
Source: Bankscope.
Securitisation markets and the current crisis
The element of this change in banks' sources of funding that I would like to focus on in
particular is securitisation. Securitisation activity did indeed increase substantially in the
years prior to the financial crisis (see Chart 3). As you know, securitisation and financial
innovation in credit markets have generated significant changes, particularly in the financial
structure of banks, and, more generally, in financial market activity in the euro area. It has
become clear that the change in banks' business models from "originate and hold" to
"originate, repackage and sell" also had significant implications for financial stability.
Securitisation was meant to disperse credit risk to those who are better able and more willing
to bear it. But, as the current crisis has shown, this did not work out as envisaged. This
stems from the fact that the same instruments that are used to hedge risks also have the
potential to undermine financial stability - by facilitating the leveraging of risk, for example.
Moreover, there were major flaws in the actual interaction among the different players
involved in the securitisation process. These included misaligned incentives along the
securitisation chain, a lack of transparency with regard to the underlying risks of the
securitisation business, and the poor management of those risks. There was a dramatic
increase in the complexity of securitised products prior to the crisis, owing largely to
misaligned incentives and investors' search for yield, which, in particular, made the valuation
and risk assessment of these products extremely complex and difficult.
Chart 3: Securitisation issuance in Europe
(in EUR billions)
Source: European Securitisation Forum.
In contrast, the covered bond market has been more sheltered from these incentive
problems than securitisation markets, partly because traditional covered bonds have a
simpler structure. This makes the overall market more transparent, and the valuation and risk
assessment easier. Covered bonds also have a much stricter regulatory framework.
Overall, there have been problems in the securitisation market that relate to opacity and
misaligned incentives, which - looking ahead - need to be addressed by market participants
and regulators in order to restore the securitisation market to health.
Money market problems as a symptom
Having gone through some of the major factors that have affected the condition of banks
during the current crisis, I will conclude by recalling not only the exceptional speed with which
the crisis hit the financial sector, but also the unprecedented size of its impact. Consider, for
example, interbank markets. In normal times, interbank markets are among the most liquid in
the financial sector. In 2006 the daily turnover in euro area money markets was €140 billion.8
The sudden seizing up of interbank markets and subsequent failure to redistribute liquidity
has become very much a key feature of the financial crisis.9 Chart 4 shows the spread
between the three-month unsecured rate and the three-month overnight index swap rate,
which is a standard measure of interbank market tension. Until 9 August 2007, which is often
said to mark the start of the financial crisis, the unsecured euro interbank market was
characterised by a very low spread of around five basis points. After the announcement by
BNP Paribas that it would freeze some funds, the spread increased by a factor of 12 to
around 60 basis points. After the collapse of Lehman Brothers and the events surrounding
the last weekend of September 2008,10 the rates shot up further, eventually reaching a
maximum of 186 basis points. The increase of rates in September 2008 is mirrored by the
amount of funds deposited with the ECB at that time.
Chart 4: Interbank market
Source: F. Heider, M. Hoerova and C. Holthausen (2009), op.cit.
The events of the last two years have not only shown that even the most liquid funding
markets for banks can seize up within days, but also proved that long-standing economic
relationships across different market segments can suddenly break down precisely as a
result of the links between banks. Future regulation will take into account liquidity risk and
prescribe sound liquidity policies.
How banks have fared during the recent financial crisis
The recent financial crisis has illustrated how banks' own business models and incentives
can have a major impact on financial stability. In this regard, recent international evidence
suggests that banking strategies that rely primarily on generating non-interest income or
attracting non-deposit funding are very risky.11 There is also evidence, for example by
Andrea Beltratti, from Bocconi University, and co-authors, suggesting that those banks that
performed better prior to the crisis have also fared worst during the crisis. This seems to
suggest that the more profitable strategy prior to the crisis, has also been the more riskier
strategy. Their research findings also suggest that there may be additional policy tools that
could contribute to containing future threats to financial stability. In particular, banks in
countries with stricter capital requirements and more independent banking supervisors seem
to have performed significantly better during the crisis. Also, banks with more Tier I capital
and in countries with more restrictions on banks' activities have also done relatively well in
recent quarters.12
The way forward
What have we learnt about sustainable bank business models from the events of the past
two years? First, it is important that the structure of banks' liabilities is appropriate for the
structure of the assets that they hold. Banks have been excessively leveraged relative to the
risks they were taking.
Second, we still know too little about why different banks hold different levels of equity.13 We
do know, however, that, ultimately, equity is the only robust buffer against realising losses.
Although holding equity is costly, bank capital regulation should also take into account the
macroeconomic implications of bank capital requirements.
Third, banks to a large extent ignored the role of deposits as a stable source of funding. More
and more assets were funded by non-deposit liabilities. Banks turned excessively to the
wholesale markets in order to finance their growth. Relying on wholesale markets for funding
and liquidity has proved to be exceedingly precarious.
Fourth, owing to its potential benefits, innovation in the financial sector will continue.
However, a serious evaluation of the possible implications of financial innovation for financial
stability is warranted. In the case of securitisation, a sharp reduction in the level of complexity
and leverage of the instruments issued is expected, while a higher level of transparency and
more aligned incentives are crucial for an efficient securitisation market.
Fifth, I would like to just say a few words on the macro-prudential aspects of financial
stability. It is very important to develop a proper framework for the macro-prudential
supervision not just of banks, but also other financial institutions, markets and instruments
that can be systemic in nature, irrespective of whether they are regulated or not. For that, we
need a deep understanding of the major trends in the financial sector, including new
business models, and their impact on financial stability.14
11
A. Demirguc-Kunt and H. Huizinga (2009), "Bank Activity and Funding Strategies: The Impact on Risk and
Return", CEPR Discussion Papers 7170, February.
12
A. Beltratti and R. M. Stulz (2009), "Why Did Some Banks Perform Better During the Credit Crisis? A
CrossCountry Study of the Impact of Governance and Regulation", Charles A. Dice Center Working Paper No
200912, July.
13
On this, see for example R. Gropp and F. Heider (2009), "The Determinants of Bank Capital Structure",
Review of Finance, forthcoming.
14
For further information on macroprudential issues, see A. Crockett, "Marrying the micro- and macro-prudential
dimensions of financial stability", remarks before the Eleventh International Conference of Banking
Supervisors, held in Basel on 20-21 September 2000. See also the Report of the High-Level Group on
Financial Supervision in the EU chaired by Jacques de Larosière, in Brussels, on 25 February 2009. In the
European Union, following the publication of the Report of the de Larosière Group, the European Commission
proposed in May 2009 a set of ambitious reforms, including the creation of a new European Systemic Risk
Board responsible for macro-prudential oversight. The European Council in June 2009 supported the
European Commission's proposal.
BIS Review 112/2009
I am pleased to note that the relevant authorities have already started to take action in
response to all these lessons that have been learnt from the financial crisis. With a view to
strengthening the resilience of the banking sector, the regulatory reform agenda that has
been launched and agreed internationally will:
•
introduce a leverage ratio, as a measure to curb banks' excessive balance sheet
growth. This measure will be introduced initially as a supplement to the Basel II
riskbased framework and, subject to proper calibration and review, as a minimum
regulatory requirement;
•
raise the quality, consistency, transparency and level of capital, namely the amount
of common equity and other instruments of equally high loss-absorption capacity;
•
introduce a framework for counter-cyclical capital buffers above the minimum capital
requirement, which will be raised during economic upturns and be used in
downturns, as well as promote more forward-looking provisions; and
•
establish a minimum global standard for funding liquidity which includes a stressed
liquidity coverage ratio requirement and a longer-term structural liquidity ratio.
These measures will be introduced by the end of the year, and phased in as financial
conditions improve and economic recovery is assured.
Measures to address the misalignment and lack of transparency of incentives in the
securitisation market include strengthening the capital requirements for exposures, as well as
introducing risk management practices and disclosures. These measures have already been
agreed and will be implemented in the course of 2010. As improving economic conditions
may lead to the resumption of securitisation activity, the measures taken will ensure that it is
relaunched on a sounder and more sustainable basis.
Finally, work is under way to ensure that all systemically important institutions, markets and
instruments are subject to adequate regulation and oversight. As a first step, a report will be
issued in November by the IMF, the FSB and the BIS that will provide guidance on identifying
systemically important institutions, markets and instruments.
I started this speech by briefly describing why banks are special. The last two years have
painfully stressed how special and important they really are. When the financial system fails,
the whole economic system is affected. The financial sector has undergone an
unprecedented wave of innovation, change, consolidation and now crisis. We now have a
better understanding of the business models that may not be sustainable, but there are still
many open questions. For example, will future capital requirements provide banks with better
loss bearing capabilities and the economic system with less procyclicality? How can future
compensation and corporate governance principles support the long term value creation of
banks? And, how can risk management practises and risk pricing models better represent
possible gains and losses? Overall, there seems to be no simple answer on banks' best
practises and their business model. Therefore, we need the contribution of the academic
community for the future design of banks' business models and for the policies supporting
them. I am - of course - already looking forward to this conference providing some answers
to the important questions at stake.