or derivatives – does not take place between individuals but rather financial institutions such as banks and investment firms. this has important implications for the functioning of these markets because it introduces several important types of frictions. as we have all witnessed in the past years, many of these entities are very large, at least in terms of their balance sheets. besides giving rise to the too - big - to - fail problem that has been at the heart of the current financial crisis, the size of these financial institutions has profound implications for the way investment portfolios are constructed and assets are traded, because it makes a large difference whether an agent wants to buy or sell 100 shares or 100, 000 shares. for large investors, the impact of their actions on market prices is no longer negligible and they potentially incur large transaction costs due to “ market impact ”, such that fluctuations in market liquidity – the ease with which a security can be transformed into cash – become a first - order concern. based on this real - world insight, acharya and pedersen bis central bankers ’ speeches developed the liquidity adjusted capital asset pricing model ( capm ), 1 which shows that investors do not only require compensation for bearing the risk associated to an asset ’ s fundamentals but also will command an additional premium related to the asset ’ s liquidity risk. their theory is strongly supported by numerous empirical studies and can explain real - world phenomena such as the episodes of a flight to liquidity that we have witnessed more than once during the past years. another salient feature of financial institutions that has featured prominently in the current financial crisis is leverage. in fact, most market participants do not finance their entire trading positions with equity but rather fund part of their investments by pledging the securities as collateral in repurchase agreements and asset - backed commercial paper. this implies that asset prices are also affected by funding liquidity, a concept that refers to the ease with which a security can be used to raise outside capital. in the years preceding the 2007 – 2008 financial crisis, leverage in the financial sector build up steadily fuelled by high demand for dollar - denominated short - term debt in conjunction with low interest rates. when the first rumours of problems in the market for sub - prime mortgages began to spread, uncertainty of exposures to potential losses directly translated into funding liquidity problems. in an equally rigorous and elegant contribution, pedersen and his co - author markus brunnermeier – winner of the 2008 bernacer

conditions, it is not yet sufficient to compensate for the low interest rate margins. the continued economic recovery should, however, reduce the negative impact of cyclical factors over time, as banks ’ balance sheets adjust. but most importantly, a number of structural challenges continue to dampen bank profitability. these factors vary across countries and banks and include incomplete business model adjustments, cost inefficiencies and excess capacity. the stock of npls also remains high at some banks. let me elaborate on each of these issues in turn. starting with the issue of business model adjustment, our analysis shows that, in the past, diversified banks have been more successful in generating higher revenues from net fees and commissions and trading when faced with pressure on interest income. this is perhaps no surprise, as banks engaging in custodian, asset management or investment banking activities are likely to be better able to gear themselves towards fee - generating activities, whereas commercial banks may not have access to such opportunities for diversification. 1 at the same time, one has to acknowledge that it is not only the low yield environment and lack of income diversification that is challenging banks ’ business models. the rapid pace of technological advances and the ensuing change in the competitive landscape are both a key strategic opportunity and a challenge for banks. for example, a shift from branch networks towards digital banking has enabled many banks, notably in the nordic countries, to reduce costs while maintaining sound customer bases and market shares. but clearly, a successful transformation is likely to hinge on the support of beneficial structural factors such as labour laws, how the market is structured and the digital readiness of the economy. policy action may thus have a role in supporting these conditions. incumbent banks also need to be prepared for the increasing competition from the non - bank financial sector and “ fintech ”, fuelled by the increasing role of technology in financial services. increased competition in lending, investments and payments is bound to increase pressure on retail banking revenues. it will subject deposits to more intense price competition, and may erode revenues related to overdrafts and payments. adjustments to business models are closely linked to the second challenge : the need to improve cost efficiency. i already mentioned that digitalisation can enable substantial cost savings. however, on aggregate, euro area banks have so far been unable to meaningfully reduce operating costs in the aftermath of the financial crisis. in fact, euro area significant institutions ’ operating expenses have increased by over 5 %, on aggregate, since 2010, despite a