The recovery of the global economy after the 2007 crisis is a certainty, although the real economy and financial markets are showing a complex and erratic evolution and, more importantly, one that is difficult to interpret. For example, regarding the evolution of some emerging economies like China or Brazil, it is difficult to assess whether we are facing a new crisis or simply a new phase of the 2007 crisis. As for financial markets, the scars of the crisis have left an environment of unusually low interest rates, extreme risk aversion, and high volatility, particularly in the banking sector on stock markets. It is therefore not surprising that a certain sense of pessimism hangs in the air, reflecting more the length and complexity of the crisis and post-crisis period than the challenges we actually face. Of course, issues such as the Brexit debate, the lack of government in our country, or the refugee crisis do not help to improve this very negative perception.
However, if one coolly analyzes the situation and accepts that the new normal, the new normal, will not resemble the false prosperity of the financial bubble, one can find reasons for optimism. And perhaps the best way to approach this perspective is to adopt a medium-term view that allows us to analyze the direction of the European banking industry, and to ask where Spanish banking stands in this medium-term journey.
Allow me to begin by outlining this path with an eye on the next five years. To do this, I will initially focus on short-term or cyclical challenges, and then address more structural issues. Finally, I will describe how Spanish banking is preparing to successfully face this more uncertain future.
In the short term, the most relevant element to sustain this optimistic view will be the normalization of the interest rate curve, an event that, when it occurs, will be excellent news for the banking sector, but also for the economy in general. We cannot ignore the paradox that the current low interest rate environment poses for banks. On the one hand, they are required to be prudent, meaning that pressure continues for them to exercise adequate risk control or, in other words, to maintain more capital and more liquid balance sheets. But on the other hand, the implementation of monetary policy encourages these same banks to take on more risk, which is contradictory and, why not say it, disconcerting.
This current interest rate environment can also inherently lead, for some banks with business model problems, to the temptation of a flight forward. That is, some entities in this situation may be tempted, given the current context, to take on credit risk without adequate control. Faced with these dangers, the appropriate response should not be to increase demands on the entire sector (through, for example, macroprudential measures), but to use traditional instruments to curb this inappropriate risk-taking by those banks that are not adequately reading the risk map. In other words, it is the supervisor’s responsibility, that of the Single Supervisory Mechanism, to act when the managers of a specific bank follow erroneous commercial and risk management policies. Herd behavior (herd behaviour) only occurs when excessive risk-taking by the first agents to deviate from the group is not penalized.
But let’s return to the medium-term view. The normalization of rates, even if they settle at lower levels than historical ones, will allow for the recovery of margins and results for European banks. A positive short-term rate and a positively sloped yield curve not only provide value to the banking business of maturity transformation but also remunerate savings, that is, they reward foregoing consumption today in exchange for consuming tomorrow, something essential to address the aging population in Western countries, including Spain.
The banking business is fundamentally a business of financing and maturity transformation. But banks also offer a series of auxiliary services, of enormous importance for the economy as a whole, such as payment services, or for the client, such as securities custody, where the user particularly appreciates the security offered by their bank’s involvement in any transaction. And this factor of security and client trust in their bank constitutes a first-rate competitive element in favor of banking entities and to the detriment of new digital operators that may emerge in these areas.
In the past, the cost of these services for banks was subsumed into other costs and recovered in interest margins. And although the client, in a way, was not aware of the cost that providing these services entailed for the bank, this was compensated because this apparent gratuity constituted a very powerful commercial element. On other occasions, I have already mentioned that, under this appearance of gratuity, an overprice was being charged in margins that, had the client known about it, they might not have accepted. Furthermore, cross-subsidies occurred between clients, favoring those who required more services and disadvantaging those with fewer needs. To the extent that the impact of the cost of services was not transparently evidenced, it hindered comparison between entities and the evaluation of their service quality, thus limiting healthy competition. On the contrary, a model of charging the client for the services actually rendered (which, logically, includes the profit margin or mark up) avoids these cross-subsidies between clients, allows comparison between entities in terms of cost and quality, and promotes healthy competition, not only among banking entities but also between them and new financial operators who will surely be prepared to offer these same services in the not-too-distant future.
In short, in the next decade, charging for services rendered will be the norm, even if, for now, commercial strategies to attract clients based on free commissions continue to be part of the differentiation tools of some entities that need to reinforce their appeal in the short term. And, undoubtedly, clients will have to get used to explicitly paying for services they previously paid for less transparently, something that will not be easy or peaceful, just as it is not in the field of the press or intellectual creations in film, music, or literature. However, in this way, they will be able to compare different service providers, probably not all of them banks, and decide which offers them the best quality at the lowest cost, as happens in so many other sectors: transparency in commissions, competition, and freedom of contract are the three factors that always guarantee that the consumer obtains an optimal result, that is, good service at the best possible price.
When observing the size of the European banking sector, it is difficult not to conclude that Europe is overbanked. This conclusion holds whether we look at the number of large entities, or at medium-sized or smaller ones. In addition to this factor, the new digital world adds pressure to reduce installed capacity.
Of course, not all countries start from the same situation. In Spain, for example, the crisis led to a reduction in the number of entities: we went from 42 banks and savings banks to 15 banks, while the number of employees and branches was reduced by approximately 30%. All this has allowed the sector to recover the size it had in the 1980s. This process of continuous improvement continues: after all, the pressure on profitability derived from low interest rates forces efficiency improvements.
Evidently, in an industry with increasing returns to scale, a very effective way to improve efficiency is through mergers, specifically of those entities where the levels of overlap are high. Thus, although in the past mergers with complementarities were attractive, now what dictates is the efficiency and profitability of the merger in very short terms.
Furthermore, we must remember that if friendly mergers are generally more effective than hostile ones, this is even truer in the banking sector. Therefore, if consolidation operations occur, they will almost certainly be friendly and blessed by the supervisor. The important thing, in any case, is that these always respond to a clear objective of economic rationality and that not only the resulting entities, but also the banking sector as a whole, emerge strengthened from them.
Another element we should see in the coming years is the emergence in the eurozone of genuinely pan-European banks, present in almost all countries and holding significant market shares in them. Why will we still have to wait a few years for this to happen? Because the current regulatory and interest rate environment makes it very difficult for any bank to propose operations that stress regulatory capital and do not produce results in the very short term. But let’s not be fooled, if the Banking Union does not lead to the creation of genuinely pan-European banks within a decade, this project will undoubtedly have failed.
In this medium term we are discussing, the pace of technological change in the banking sector will already be evident.
This change will impact two areas. Firstly, new developments in fintech will, within a few years, demonstrate their viability and ability to successfully compete with banks. And secondly, the penetration of e-banking: the speed at which customers abandon traditional banking channels in favor of new online options will also become clear within this relatively short timeframe.
Regarding the first block, it is impossible to evaluate the impact. But we should not lose sight of the fact that the most important thing lies in the technological developments behind each proposal: blockchain technology more than bitcoin, big data more than peer to peer lending. My intuition is that some of the mentioned developments (bitcoin, or peer to peer lending) will not mature as expected, either due to aspects related to the opacity of the proposals, or because the credit cycle will demonstrate sooner rather than later how difficult it is to correctly select risk. This will not minimize the impact: after all, we must not forget that blockchain technology, the secure encryption of transactions without the intervention of a third party, can radically change custody businesses or even securities settlement. The message is that the disruptive element will be the technology, rather than the specific initiatives.
As for the second element, the speed of change to online channels and the abandonment of traditional ones, it will probably be intense in the next decade. It is not just a generational issue (after all, millennials, digital natives, are increasing every year), but entities themselves are already improving their offerings and adapting traditional channels to the new digital environment. It is interesting to observe how internet penetration evolves among users for specific daily tasks, whether with the Administration or with their reference financial institution. Thus, a recent study by Fundación Telefónica noted that the increase in internet use among non-digital natives (between 55 and 64 years old) was 10% in just three years. Therefore, it is not just that millennials are becoming increasingly important, but that the implementation of internet use across the entire population is becoming clearer and more intense. It is clear that this new way of doing business is here to stay.
But if there is one area where everything must change in the next five years, it is in the regulation of this new digital environment. If not, the new environment could not develop, and if it did in part, it would be outside the law. This is a risk we cannot take. This new regulatory environment must consider three areas. Firstly, it is necessary to rethink many of the current regulatory principles in chapters such as anti-money laundering or investor protection. How to apply the Know Your Client principle in a new digital environment, where remote access is the norm? And how to apply the MiFID guarantees in this new environment? Can a website engage in misselling?
Secondly, and as we have reiterated, it is fundamental that the current guarantees for banking clients be extended to this new internet financial world. In other words, it would be a huge mistake to allow the development of e-finance at the expense of consumer protection. Or even more clearly, we do not accept that transactions that potentially cause the same risks are subjected to looser regulation when they are not carried out by banks: equal risks, equal rules. And finally, one must ask whether the slow-moving EU regulatory system, with the Commission, the Council, the Parliament, and the national transposition of Directives into Laws, is prepared to respond to such a dynamic and changing world. Let us remember, again, that either regulation tries to respond to e-finance or it will develop outside of it.
In the next decade, supervision within the framework of the SSM and led by the ECB will already be a well-established reality. The initial problems of both the lack of homogeneity in the regulations applicable to banks (today, even the so-called national discretion options are already on their way to disappearing) and, more importantly, the residual heterogeneity in supervisory practices that we observe today will have completely vanished. Furthermore, at that time, the reformist impulse given after the Great Recession of 2007 will have given way to relative regulatory stability that will facilitate the implementation of the new supervisory model, as well as equal treatment for supervised entities (the so-called Level Playing Field). Finally, it is more than probable that some pending pillar of the Banking Union, such as the single European deposit guarantee fund, will already be a reality in the next decade, thus completing the ambitious European project.
What can we expect from the maturation of pan-European prudential supervision? Ideally, this more homogeneous supervisory model would allow for greater discrimination, through supervisory actions, between better and worse banks (in terms of business model stability, risk control, governance, etc.). But it is more likely that the complexity of a supervisory system with 120 banks operating in different eurozone countries will lead to a model based more on detailed rules than on discretionary supervisory actions.
But the integration of supervision may not stop at the banking sector. Can progress be made in supervisory coordination within the eurozone for other sectors, such as securities or insurance? I believe so, although it is difficult to assess both the timing and the depth of the reforms.
Also in the next decade, we will see the European resolution authority, the SRB or Single Resolution Board, in action, which will allow us not only to assess the adequacy of the Resolution Directive but also the coordination between the different authorities involved in these processes (the SRB and the SSM, including local authorities). However, to appreciate the benefits of the new European bank resolution scheme launched after the crisis, a crisis of a significant banking entity would need to occur, which is not desirable.
Finally, the fate of the Capital Markets Union project will also be clarified in the next decade. It is a very important and highly complex project, which will require not only extended timelines but also political support that goes beyond the current European Commission’s calendar. If this support is truly maintained, we should see deeper and more diversified capital markets, capable of financing the real economy and providing financing alternatives that complement those of banks. Banks, for their part, will be active participants in the CMU, facilitating their clients’ access to these deeper and more diversified markets when they constitute a reasonable alternative to bank financing.
Banking culture, understood as the set of values that shape the conduct of banks and their employees, is destined to play a central role in banking over the next decade. This mechanism will contribute to generating trust in banks and a positive reputation among the main agents involved in banking activity, both internal (employees and managers) and external (shareholders, clients, and suppliers).
As I have reiterated on more than one occasion, this is not a matter of regulatory compliance, which exclusively concerns the relationships between clients and entities. Nor is it about having adequate corporate governance, an important pillar undoubtedly, but not exclusively. It is about the integration of all these elements into practical life, into the day-to-day operations of entities.
In a business based on trust, it is obvious that an appropriate banking culture, firmly rooted in the organization, is a key element for medium-term survival.
An appropriate tone from the top that is transmitted throughout the organization, and a continuous effort to reinforce these values for all employees, will prevent problems from arising in the future. In any case, the SSM officials have made it clear that, even if they will not specifically regulate banking culture, they will monitor banks’ initiatives in this area.
Our model of close customer banking and accompanying them throughout their lives should particularly benefit from this alignment between customer interests and those of the entity, and also from the emphasis placed on banking culture in the medium term.
In short, and by way of conclusion, I am not revealing anything new by saying that the sector continues to be exposed to an adverse business environment in which low interest rates and regulatory uncertainty make it difficult to achieve the profitability demanded by shareholders. In this context, banks must find a way to make financial intermediation profitable, while strengthening their balance sheets to comply with demanding regulatory changes and trying to satisfy shareholder demand in the form of profitability close to or above the cost of capital and guarantees of business sustainability.
Our banks, however, are not starting from scratch. They have been facing the demanding regulatory requirements established for this post-crisis new normal for years. The most important part of the regulatory journey has already been covered. Profitability, for its part, is beginning to show improvements, albeit slow ones. The exit from the crisis can be considered overcome, and what is needed now is to lay the foundations for achieving a more favorable outcome as the Spanish economy advances in the upward phase of the cycle.
Within this challenging framework, Spanish banks have other elements in their favor. Our sector has already made a significant adjustment to its productive capacity, which gives it a comparative advantage over its international competitors. And this process continues, as we have seen from the decisions of several entities, announced a few days ago, to adjust staff and branch networks to new market conditions.
It is clear that Spanish banks are not resting on their laurels and are agile in making the right decisions to remain among the most efficient in the world. And this, in part, is thanks to their experience in this process of technological change that they have been carrying out uninterruptedly since the mid-20th century and which constitutes an excellent springboard from which to leap into the digital world.
From my words, one might deduce that I am an unrepentant optimist. On the contrary, and contrary to the saying, I am an informed pessimist: I am convinced of the capabilities of Spanish banks which, if they have demonstrated anything in recent decades, it is their prodigious capacity for adaptation and overcoming adversity. But neither can we ignore that not everything depends on us. Firstly, to maintain this improvement, it is essential that the Spanish economy remains in this upward cycle for several more years. To do this, it needs political stability and economic management that allows it to correct its two endemic imbalances: external debt and unemployment.
The second factor refers to the need to conclude the post-crisis regulatory process, which seems endless. Banking entities require a stable, predictable regulatory framework and transparent supervision in their more discretionary actions for the design of their strategies and the definition of their business model. It is time, therefore, to put an end to this regulatory cycle, begin to evaluate its global impact on the industry, and refine the new framework from its unintended consequences.
And the third and final decisive factor is the normalization of interest rates, without which the recovery of profitability for the global banking industry seems extremely difficult.
In conclusion, banking in Spain, as is happening in the rest of the world, is facing a change that demands a new way of operating and behaviors ranging from the development of financial culture to digitalization. Our banks have to make many strategic decisions about this entire process. They must decide what kind of entity they want to be in ten years, what products and services they want to provide and how they want to do it; what relationship they want to have with their clients and with other stakeholders; what size they wish to have and in which jurisdictions they want to operate; with what cost structure they will be able to operate and what investments in technology they must make to compete in an increasingly complex world. Spanish banking is in a position to continue globally leading an exemplary business model that lays the foundations for a strong and solvent industry, capable of fulfilling its essential function of financing Spanish companies and families, and those in other countries where it operates, for a long period of time. This is our challenge, nothing more and nothing less.
Thank you very much.
José María Roldán, Chairman of the Spanish Banking Association
