Gertrude Tumpel-Gugerell: The role of retail finance for financial markets
efficiency and stability
Speech by Ms Gertrude Tumpel-Gugerell, Member of the Executive Board of the European
Central Bank, at the Eleventh Conference of the ECB-CFS Research Network, Prague,
20 October 2008.
* * *
Introduction
It is for me a real pleasure to speak here in Prague at the European Central Bank and Centre
of Financial Studies Research Network conference. I would like to thank the organizers of the
conference for compiling a very interesting and stimulating program. My special thanks go to
our host, the Czech National Bank, for the very good cooperation and for an outstanding
local organization of this conference.
Being here in Prague, I was reminded that Joseph Schumpeter was born not too far away
from Prague in a small town named Třešť. It was Joseph Schumpeter who once said that
"economic progress in capitalist society means turmoil". It would be, of course, unfair and
undue reference to associate Schumpeter's notion of turmoil with the current period we are
experiencing in financial markets. In my speech today, I would like to focus on the retail
banking sectors' contribution to efficiency and stability in financial markets also in light of the
ongoing financial market turbulences. I will also stress the importance of retail payment
infrastructures, and particularly the issue of harmonisation and integration as it underlies the
Single European Payment Area (SEPA) project as a fundamental basis for the efficiency and
stability of the European retail finance market.
1. The role of retail banking for economic development and monetary policy
(i) Retail banking plays a crucial role in fostering economic activity
Retail banking is the backbone of banking activities. Retail sector banks, in particular, have
the expertise to provide credit to small and medium-sized enterprises (or SMEs) and to
evaluate the associated risks. As SMEs are the main engines of job creation and economic
growth, they are also important drivers of innovation in the economy. Therefore, an efficient
and stable retail banking business is needed for the financing of SME activities. As these
firms do not have access to global capital markets, they are heavily dependent on banks for
their funding. This is particularly true for European SMEs, as the European market for
venture capital remains very small compared to the one in the US. The availability of bank
credit is, thus, crucial for sustained investment of firms and, therefore, plays an important role
for economic development and growth.
(ii) Integrated retail banking markets can enhance the effectiveness of monetary
policy
For the retail banking market to be as innovative and efficient as possible, market integration
of the retail banking sector is key. It is crucial that borrowers and depositors are charged
similar fees and costs for similar banking services across the euro area. However, most
indicators of retail banking integration suggest that there is still significant room for closer
integration. For instance, the dispersion of lending rates charged by banks to households
and non-financial corporations has remained relatively high across countries. Also quantity
indicators of banking integration - while suggesting that banking market integration was
boosted by the introduction of the euro - remain at relatively low levels.1
The low levels of integration can generally be attributed to differences in the national
economies, institutional factors and financial structures. These factors include differences in
credit risk and pricing models, differences in taxation and regulation but also the relatively
high level of fragmentation of retail infrastructures.
Therefore, more efforts with respect to integration of the retail banking sector are needed.
Not least, since, first, a more efficient and integrated retail banking sector would lead to a
better allocation of credit to innovative and growing companies, and second, from a
macroeconomic perspective would contribute to both fostering economic growth and
strengthening of the transmission of changes in official interest rates to the economy and,
thereby, enhancing the effectiveness of monetary policy. At the same time, the recent
turbulences in financial markets remind us that any further integration process has to be
guided by appropriate provisions to safeguard financial stability.
2. Changes in the retail banking business model over the past decade
(i) Increase in market-based funding
Over the past decade there has been a significant transformation in banks' business models,
away from the traditional model based mainly on retail deposits towards a more
marketbased funding model. The significant recourse to specific funding instruments, such as
mortgage bonds and securitisation, have made banks increasingly more dependant on
money and capital markets, but at the same time, of course, less dependent on their
opportunities to expand customer basis for funding. Although customer deposits still
constitute the largest part of banks funding base, their share as a percentage of total assets
of the euro area banking sector has been declining. This is shown in Chart A.
In the last ten years the access to market-based funding and wholesale deposits have
allowed banks to raise large amounts of funding at relatively low costs in order to finance the
provision of new loans. To the extent that more stable retail deposit financing has been
replaced by short-term wholesale funding, banks may have become more exposed to
interest rate and liquidity risks. More recently, with the financial market turmoil the
shortcomings of this increasing dependence on financial markets has become apparent.
(ii) Diversification in the sources of revenues
The increased diversification of banks' income sources via higher brokerage fees and
commissions - what is more generically called "non-interest income" is another structural
trend in banks' changing business models. The diversification of income provides banks with
additional sources of income - empirical studies concerning the effects of income
diversification on profitability tend to conclude that there has been a positive correlation
between non-interest income and profitability - and allows banks in principle to reap the
benefits of diversification. Literature concerning the impact of diversification in the sources of
revenues on the volatility of banks' earnings point out that there has been some stabilisation
effect of income diversification on profits, due to the negative correlation between
noninterest income and interest income, but that non-interest income has been more volatile
than interest income. However, an important aspect relates to the potential impact on
financial stability. Recent literature investigating income diversification effects on financial
stability conclude that in general income diversification tended to increase systemic risk.2
Indeed, even though income diversification tends to increase profits, and that strong and
profitable banks are better able to absorb losses and thus strengthen financial stability, this
strategy at the same time can increase financial stability risks as the increasing reliance on
non-interest income sources entails a higher exposure of banks to the major global risks, and
in particular those related to capital markets. Also, diversification implies that institutions
become increasingly involved in similar sets of activity; in this case, it becomes more likely
that whenever an institution faces difficulties, others do as well. This increased
interdependence might propagate, and, possibly, amplify shocks at a systemic level.
Once again the current financial market turmoil has revealed the weaknesses underlying this
change in the business model.
(iii) An example of pronounced market reliance: US investment banks
An extreme example of high dependence on non-interest income would be the case of the
US investment banking houses. Chart B shows that US investment banks are also typically
more profitable than commercial banks but also shows that their earnings are more volatile
than those of commercial banks. The large European universal banks are, in terms of profits,
somewhat in the middle between commercial and investment banking. This is more or less
expected given their broader business model nature combining both retail and investment
banks activities. The drop in profits from 2006 to 2007 experienced by investment banks was
much more pronounced than for commercial banks, Chart C.3
(iv) The relation of the changes in the business model to the ongoing financial
market turmoil
The financial turmoil has starkly illustrated that market-based funding is heavily dependent
on market perception, including trust and confidence. Deposit funding has proven to be more
stable during the ongoing financial market turmoil than other sources of banks' funding.
While there are of course other factors at play Chart D shows that during the ongoing
turbulences the market has valued more positively those institutions with more funding via
customers' deposits. Related to this, the recent events illustrate the benefits long-term
relationships of banks with depositors and borrowers.
As mentioned before, the financial turmoil has also illustrated possible implications of banks'
changing business model for financial stability. Let me emphasise that, in principle, market
funding and in particular securitisation can provide significant benefits in terms of risk sharing
and diversification. However, the recent crisis has highlighted some features of those
markets which can strongly impair the orderly functioning of markets.4
For ensuring an orderly functioning of the market, transparency is crucial. Banks need to
properly evaluate and disclose risks and use proper valuation techniques. For this we need
"good" regulation. A regulation that gives the right incentives to contain risks, but also
regulation that is flexible enough to adapt to innovations in financial markets, allowing
financial innovations that help to enlarge the capacities for investment and growth and the
diversification of risks in the market.
The importance of retail banking is likely to revive against the background of the ongoing
turmoil. Efficiency and competition in that sector is certainly of high importance. Nonetheless,
to ensure a smooth functioning of the retail banking market, we need to have "good"
regulation and stable infrastructures in place, which brings me to the second part of my
speech on the role of retail infrastructures.
3. The Single Euro Payments Area (SEPA) changes retail payment business
(i) SEPA is important for retail banking
The realization of the Single Euro Payments Area (SEPA) is important for two reasons. First,
it will contribute to creating a competitive and integrated European retail payment market and
thereby fostering innovation and growth in the retail banking sector. And second, at the same
time SEPA will contribute to a smooth and safe underlying payment infrastructure which will
provide the basis for stable transactions on a retail banking level, contributing to
safeguarding financial stability.
With SEPA individuals and corporates are able to make their cashless payments throughout
the euro area from a single payment account anywhere in the euro area using a single set of
payment instruments as easily, efficiently and safely as they can make them today at the
national level.
Especially, at a time when other sources of income for banks are more volatile, payment
services will contribute to banks' business as banks can count on reliable and regular
revenues generated through payment services. Payment services are an important part of
the banking industry, accounting for more than a third of the operational costs of banks, and
around 25% of their revenues. This is also reflected in the fact that according to the latest
figures, non-cash payment transactions of European countries grew on average at an annual
rate of 7% in the past six years stemming from ongoing modernisation of payment means
and systems.5 Moreover, payment services are also important in helping banks to establish
long-term relationships with their customers, private individuals as well as corporations. From
an economic perspective, efficient and safe payment systems are important in facilitating real
and financial transactions in advanced economies.
The Eurosystem continues to support the creation of the SEPA, in which it plays an active
role as a catalyst and offers a platform for debate among the various stakeholders regarding
the advantages of a fully integrated market for retail payment services.
(ii) SEPA spurs overall economic growth
SEPA makes an important contribution towards a more integrated payments market in
Europe, which will foster financial market efficiency and bring substantial economic benefits
to society.
As it was also shown today at this conference, SEPA offers an enormous potential to banks,
non-banks, corporations, and consumers, and society as a whole. Also a recent ECB study
concludes that banks may significantly reduce their costs, but will face increased competition
putting downward pressure on prices and revenues.6 Already today, prices for payment
services have gone down in a number of euro area countries. SEPA will also offer market
participants an opportunity to market new, value-added services related to the payment
chain. Further empirical evidence supports the view that harmonisation and standardisation
of retail payments processing across the euro area are likely to create economies of scale in
the provision of payment services in Europe. Significant cost efficiency gains can be
expected from continued consolidation across borders.7
Overall, SEPA will bring greater standardisation and harmonisation in the retail payments
market thereby promoting competition, and innovation. At the same time, SEPA plays a
crucial role for fostering efficiency and stability in the retail banking sector.
(iii) Overcoming the "final hurdles"
A major milestone in the direction of greater harmonization was the launch of SEPA Credit
Transfer in January 2008. Preparations for the SEPA Direct Debit (SDD) have progressed
well and the SDD launch is scheduled for 1st of November 2009. Work is also ongoing on
epayments and mobile payment channels, as well as on improvements to the SEPA Credit
Transfer.
In a time in which banks are under stress, it might be tempting to slow down the process of
modernisation and innovation of payment services. But the opposite is needed. The new
SEPA standards need to be implemented and the old ones should phase out. We need to set
an end date for the final realization of new products and processes and find clarity on the
pricing of services.
This is easier said than done and requires the efforts from all stakeholders: banks, customers
and public authorities. More initiative is needed and much more work remains to be done to
complete the SEPA project. SEPA can play a crucial role for fostering efficiency and stability
in the retail banking sector.
Conclusion
To conclude my remarks, retail banking has proven to be an area of stability within the
banking business during the recent months in credit markets. It plays a crucial role allowing
savings to flow efficiently to borrowers via credit. "Credit" comes from the Latin word
"credere", which means "to believe". This symbolizes that trust is a crucial prerequisite for the
functioning of credit markets at a retail banking level as well. If this trust is disappointed
uncertainty can soar with serious consequences for the functioning of financial markets.
Therefore, trust can only stem from good and transparent business practises, sound
business models of banks and robust and stable retail banking infrastructures.
SEPA can make an important contribution in that respect. It provides a single European
integrated retail payments infrastructure that contributes to efficient but at the same time
stable financial markets at the retail level. Authorities as well as the private sector need to
strive for further progress in the field of payment infrastructures not to loose the momentum
in creating an integrated and harmonised retail market in Europe.
This conference offers a good opportunity to discuss recent advances in the field of retail
banking it provides an important contribution to better understand developments in retail
banking. I wish all of us continued stimulating presentations and fruitful discussions.
Finally, let me stress that I see retail payments as promising avenues for future research. It is
only recently that retail payment issues have received greater priority on the academic
agenda with efforts being made to analyse essential elements and the evolving dynamics of
the retail payments industry. Against this background, let me draw your attention that the
European Central Bank and De Nederlandsche Bank will be hosting a conference entitled
"Retail payments: integration and innovation" on 25-26 May 2009. With this conference, I
anticipate two days of interesting discussions on highly topical and relevant issues relating to
retail payments. Maybe we will meet each other again next year in Frankfurt.
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