Banking business model: challenges and opportunities
IX Financial Meeting. "Transformation of the banking industry in a new setting
of digital innovation"
Margarita Delgado
Deputy Governor

Good morning.
It is a pleasure to participate in this ninth edition of the Financial Meeting, a classic in our
calendar widely acknowledged for its prestige and which gathers together a large number
of banking industry leaders. I thank the organisers for their kind invitation to me to speak at
the start of the event. And it is a pleasure to follow on from Ramón Quintana, my
"brotherin-arms" over the course of intense years of work, first at the Banco de España and then at
the European Central Bank.
Indeed, in connection with Ramón's words, and in this my first address as Deputy Governor
of the Banco de España, I wish to focus on the banking business model and the need to
adapt it to a changing environment.
Like all private companies, banks can only survive in a stable fashion over time if they are
profitable. And, set against the current transformation of the banking industry, ensuring
profitability over time calls for a comprehensive, strategic and individualised reflection on
the business model.
Allow me to develop this idea of "comprehensive, strategic and individualised". In doing so,
I will perforce refer to some of the findings included by the Single Supervisory Mechanism
(SSM) in its recently published thematic review of the determinants of profitability and
business models.1
A comprehensive reflection
Taking the first adjective, when I say a comprehensive reflection is necessary I refer to the
fact that a bank should examine its income and costs at the greatest level of detail possible:
by product and not by customer, by business line and by geography. It should seek to gain
detailed knowledge of which activities generate recurring profits, and which occasional
profits or even losses, delving into the reasons that may explain each of these results.
This will allow the bank to identify whether there is scope to turn the profitability of certain
activities around, or whether it is better to change tack or abandon such activity. In addition,
the bank will be in a position to judge whether the reality of its business, understood as its
assets/liabilities mix, and the decisions taken in and bearing on such activity are appropriate
or need adjusting.
In short, if the bank has advanced tools to improve profitability, it can develop an
appropriate, consistent and comprehensive price-setting policy to ensure that the price it
charges for a product or service matches its total cost, including the risk premium.
I should like to highlight this latter aspect of price-setting policy at the level of products or
services since, traditionally, services that are not explicitly charged and whose cost has
been covered by the net interest margin have been provided to customers. I believe it is
important to introduce transparency and rigour into price-setting. Without it, the reality of
the business is distorted as is, consequently, the attendant analysis, and informed decision-
making is hampered. Not in vain, in the aforementioned thematic review price-setting is
included among the areas where the SSM recommends making improvements.
I would further stress that, in this comprehensive analysis of the bank's accounts, there
should be some thought on the weight of operating expenses. Unquestionably, Spanish
banks have made a great effort in terms of capacity adjustment in recent years. Numbers
of staff and offices have fallen approximately by 32% and 40%, respectively, from their 2008
peaks. It is necessary to continue paying attention to these expenses, so as to ensure they
are in step with developments in lending activity and in revenue.
Against this background, progress in new technologies, and the alternatives these offer to
the traditional means of providing bank services, may prove an opportunity to cut costs and
come into line with the change under way in the customer-bank relationship. However, the
digitalisation path should be pursued after a cost-benefit analysis, having regard to the risks
and additional costs that are taken on. It should, moreover, be accompanied by processes
that allow for the identification, monitoring and mitigation of such risks, in such a way that
ensures they are included in price-setting models.
In sum, any effort geared to obtaining comprehensive knowledge of the profitability of the
activity being pursued and to refining price-setting processes with a long-term vision will be
time well spent.
That said, while the foregoing condition is necessary for ensuring sustained, profitable
activity over time, it is not however a sufficient one. The analysis must, moreover, be
strategically oriented to anticipating future changes. Reflection is needed on the capacity of
banks to manage and strategically focus the business.
A strategic reflection
Reflection on the business model should allow medium and long-term objectives to be set
and a path plotted towards attaining these objectives. Appropriate business models are
those that generate recurring and sustained profitability over time, this being the
fundamental pillar for the organic generation of capital. This is the virtuous circle that must
be drawn and, to do this, banks' management bodies will have to take the necessary
measures enabling them to face a changing and demanding future.
This task will involve taking into account all factors that may affect how the bank pursues
its business, and everything that defines its environment which, by definition, is a changing
one. By way of example: geopolitical considerations, present and future macroeconomic
scenarios, regulatory and supervisory developments, technological developments and the
emergence of new competitors.
The bank must also take into account its starting point, its strengths and weaknesses, and
how it compares with its peers.
As you all know, new competitors need not be other banks, but the so-called fintech
companies, which are destined to exert pressure on and accelerate the ongoing
technological renewal of financial institutions. Undoubtedly, therefore, part of banks'
strategic drive should focus on how to face this challenge and the competition.
I would next like to address four key aspects from the strategic standpoint: capital; the
legacy of non-productive assets; liquidity; and governance.
As regards capital, while Spanish banks have strengthened their capital base and,
consequently, have improved their ratios in recent years, duly meeting the minimum
requirements, there are no grounds for complacency.
Firstly, although the current situation is that Spanish banks have, on average, high asset
density (measured by their risk-weighted assets) and low leverage levels, it is also a fact
that they continue to have lower capital ratios than their European peers. On EBA data for
March 2018, Spanish institutions' CET1 solvency ratios are below the EU average at that
date (14.4%).
This shows that Spanish banks must continue making headway in one of the key elements
of the new rules of play, namely that they must have more and better-quality capital than
before the financial crisis.
Secondly, while there is now greater certainty than some years back about regulatory and
supervisory capital requirements, some factors continue to put pressure on capital ratios.
These include the end of phase-in periods, which have enabled certain requirements, such
as the capital conservation buffer, to come into force gradually over the course of several
years.
Thirdly, regarding resolution regulations, compliance with loss absorption-related minimum
requirements for own funds and eligible liabilities (MREL) poses a far from negligible
challenge, especially for that segment of banks that finds it most difficult to tap the markets
for funds. Part of the challenge lies in the low profitability of banking activity and in the high
cost of issuing eligible liabilities.
In this scenario, it is essential that Spanish institutions pay due attention to the organic
generation of capital in the design of their strategy and contemplate the steps needed to be
well-prepared for the future regulatory scenario and to improve their relative position in the
European banking industry.
Another key element in the design of Spanish banks' strategies should be to persevere with
the efforts made to date to reduce non-productive assets.
Having regard to the figures for business in Spain, the resident private sector's
nonperforming loans have fallen by 60% from their end-2013 peak. At that time, they accounted
for close to €190 billion. This figure was practically €75 billion as at June 2018.
In terms of the NPL ratio, the early-2014 peak was 13.9%. As at June 2018, the figure stood
at 6.4%.
The effort is clear to see. It is too in terms of foreclosed assets, which have fallen by almost
40% from their 2012 peak, and stood, as at June 2018, at around €60 billion.
Nonetheless, the foregoing figures remain high in historical terms and dynamic management
of these types of assets by banks remains necessary. They must set ambitious but credible
objectives.
In designing these objectives, banks should bear in mind the supervisory expectations
defined over the past 18 months. In particular, they should be very mindful of the guidelines
the SSM published in March 2017 and the addendum thereto released in March 2018.
The guidelines are predominantly qualitative. They describe measures, processes and best
practices in the management of non-performing exposures, with a view to banks defining
strategies that enable them to reduce the accumulated volume of such exposures.
The addendum complements the guidelines and sets supervisory expectations as to the
prudential provisioning levels for new non-performing exposures, considering as new those
classified as such as from 1 April 2018. These expectations set a timeframe of two years for
100% provisioning of unsecured exposures, and one of seven years for 100% coverage of
secured exposures. In this latter instance, moreover, provisioning is expected to be gradual,
such that it is not left until the last year to set aside the provision.
Both documents, the guidelines and the addendum, clearly demonstrate the attention the
supervisor has been paying to credit risk in general, and to non-performing exposures in
particular, and they represent the benchmark supervisory tool in the supervisory dialogue
with banks. In July 2018, the ECB announced that, along with the foregoing, and with the
aim of achieving similar coverage of the flows and stock of non-performing loans, the setting
of bank-specific supervisory expectations in respect of prudential provisioning levels for the
stock of non-performing loans would also form part of the supervisory dialogue. The better
prepared institutions are for this dialogue, the more fluid it will be.
Before addressing the last of the key strategic aspects I wish to talk about today, namely
governance, I believe it should be said that any strategic reflection should also include
appropriate liquidity planning. This should take into account those elements that may most
affect it, with particular attention to monetary policy implementation decisions.
To conclude these considerations on strategic reflection by banks, I shall refer to
governance and risk management.
The crucial element for being able to properly manage and attain profitable business models
over time is to have suitable governance structures. Governance structures shape the
decision framework on risks. They are thus determinants of how a bank's risk profile
develops and, ultimately, of its medium and long-term sustainability. They are a necessary
and basic element without which success in any project cannot be expected.
As many of you know, governance is an area in which I have been working for some time
and with which I am very familiar. Let me recall for you the areas of improvement banks still
have to tackle and which decisively influence the business model and future challenges.
Admittedly, considerable progress has been made in recent years in relation to governance.
But I would like to highlight two areas where we must continue working: i) the functioning of
boards; and ii) the implementation of risk appetite frameworks.
On boards there is scope for improvement in terms of independence, dedication and
succession planning. Many institutions have carried out self-assessments of how their
board works, but more still needs to be done as regards the time dedicated to preparing
meetings and board oversight of control functions.
The oversight of managers and, in particular, internal control functions must be
strengthened, especially in risks and compliance. And let us not overlook the quality of data
and information on risks that are pivotal to determining strategy and decision-making.
In addition, work remains to be done on integrating the risk appetite framework into
management, as a key instrument of risk control. For example, at many banks the
involvement of the risks function in the limit-setting process is still poor and lacking in
ambition.
In risk management, structured decision processes are needed, with incentive
arrangements that are conducive to sustainable risk-related decisions. How these decisions
materialise, which in the literature is known as "risk culture", is particular to each bank and
the responsibility of each one. Supervisors observe and assess but, ultimately, this is one
of the idiosyncratic aspects of banks' DNA.
In short, governance structures should be capable of measuring, heading off and analysing
current risks and those that are arising. While there are no strong signs of any easing, for
activity as a whole, in lending conditions and of aggressive pricing that might suggest that
risk is not sufficiently reflected, banks must be careful to retain a suitable profitability/risk
trade-off that is sustainable over the cycle in all business segments.
An individualised reflection, adapted to the characteristics of each institution.
I shall conclude with a brief but nevertheless important reference. In addition to being
comprehensive and strategic, reflection on the business model should also be
individualised, i.e. adapted to the idiosyncratic characteristics of each institution. Indeed,
the findings of the SSM thematic review of profitability and business models show that there
is no one single approach and that, even among those banks with better profitability results,
there are differences in strategies.
Some pursue strategies geared to obtaining high income, which counter relatively high
costs. Others place an emphasis on low costs that are compatible with relatively low
income. And others strike a balance between a medium income-generating capacity and
medium or low-level costs.
These differences in strategies are reflected in different action plans, some aimed at growth
in loans or commissions, others at streamlining costs through various means, including
digitalisation or externalisation.
The options are varied and should be adapted to the actual circumstances of each bank.
Conclusions
In conclusion, my address has focused on the importance of reflecting on the banking
business model as a cornerstone for being able to achieve a sustainable level of profitability
over time. I have stressed certain elements central to this reflection, such as detailed
knowledge of the reality of the business, a price-setting policy that reflects the risk and cost
of each product, a strategy geared to strengthening capital and reducing non-productive
assets, sound governance and an individualised and tailor-made strategic approach.
Banks are preparing for the future and the new times ahead, although nobody knows for
sure what this will be like. What is clear is that only banks that are proactive and better
prepared from the strategic standpoint will be capable of exerting influence over their
profitability and sustainability over time.
Thank you for your attention.