European banks improving performance but remain behind the game

27 June 2016

The European retail banking sector has seen its operations improve since the hard times that followed the 2008 financial crisis, with the Nordics in particular as star performers. However, profitability per customer and cost-to-income ratios remain lower than pre-crisis levels and, according to a new analysis, banks will need to work hard to improve their performances to meet RoE expectations of 15% or more.

The European banking industry remains under a cloud since the financial crises came close to spelling out unprecedented financial catastrophe. While the sector was bailed out, the effects of the crisis continue to linger within the industry and Europe more widely. As it stands, conditions remain relatively tough for financial institutions — as persistently low interest rates, higher capital requirements and changing customer expectations introduce a range of challenges. In addition, many incumbent banks are still operating legacy hardware and software at a time in which FinTech players are leveraging the latest technologies to woe customers.

In addition, banks also face a lacklustre macroeconomic environment in Europe, as growth rates remain sluggish. Europe’s gross domestic product (GDP) growth rate was 0.5% in the first quarter of 2015, but slipped to 0.4% last spring and was at 0.3% by the second half of the year. There is some good news, however, with low energy prices and low interest rates promoting the capacity for consumers to spend; consumption has been positive over the past two years while nominal disposable income increases are on the rise.

Consumer spending and confidence are increasing in Europe

The new normal
A.T. Kearney’s latest 'Retail Banking Radar' study, which involves a study among 90 retail banks in 22 European countries, sheds light on the latest trends across the continent. The Western European banking industry had a relatively uneventful year in 2015, while profitability was up 18% due to a continued reduction of risk provisions, as banks clean up their balance sheets and remain cautious about new risks, revenue was relatively stagnant at 2.4% higher. At the same time, operating costs and cost-to-income ratios remain high, with no real improvement since 2008. Headcount has continued to decrease, down a further 1% last year and 8% down on 2008; many of the lost staff were lower level branch employees, which have been replaced by a few higher level, more expensive, IT staff — resulting in little benefit in staffing costs.

Bank closures are intensifying across Europe

Branch closures
The development of digital channels through which customers are able to perform a range of services, for themselves, have been on the increase in recent years. While the service benefits customers by way of improved efficiency, for banks it also meant that they could rationalise away the branch as footfalls fell.

Particularly Western European countries have seen significant falls in branch numbers, in the Benelux regions for instance, numbers fell by almost 12%, while in the UK there was a 10% drop. In Southern Europe, which has considerably higher density for branches per inhabitant, an average fall of almost 25% was noted — mainly due to Spain’s large drop.

Historic performance comparison of retail banking market

Post-crises levels
The cut in branches and their overheads has not resulted in a significant cost reduction for banks over the past years, with many banks still underperforming from prior to the economic crisis. In terms of cost-to-income ratio, prior to the crisis the average stood at 60%, while in 2015 it came in at 62%. Profit per customer averaged €201 in 2015, well down on 2007 when it stood at €210.

The numbers for 2015 do reflect improvements on the year previous, however, as risk provisions relative to total income fell to 8%, while income per customer was up from €650 to €665 and income per employee was up from €230,000 to €244,000. The biggest change was in net interest income relative to total income, due largely to changes in European wide rates.

Regional retail
The research also took a more granular look at the retail banking segment across various countries. Western Europe’s retail banking industry, the report finds, enjoyed rosy results last year — profit per customer increased by 9%. However, there are different sides to the story. Austria, Benelux, and the United Kingdom saw strong increases of between 11% and 29% (net of exchange rate effect in the United Kingdom), while France posted a more moderate 6% gain, and Germany had a small loss of minus 3%.

Country differences in retail banking

In Southern Europe significant improvements were booked last years as banks saw profit per customer surge 157% to €134, backed mainly by a 12% reduction in risk provisions, the strongest in Europe. The region is still well behind its pre-crises levels, however, when profitability per customer was above €300 — the region is dragged down by still-low income per customer (14% below 2007) and higher risk provisions related to total income (11% above).

The top performers last year were the Nordic retail banks, which managed impressive cost-to-income ratios of 48%, which boosted profitability by 9%. Nordics also enjoy a favourable market environment with even lower loan loss provisions compared to 2014, as well as a digitally adept populace.

Championing cost
The analysis further considers a more complete interpretation of cost comparison, which it calls “total efficiency ratio” (TER), calculated by cost-to-income ratio plus loan loss provisions/income. If a bank operates in a low risk environment with minimal loan loss provisions (LLPs), this will equal its cost-to-income ratio; if it operates in a market confronted with high LLPs, its cost-to-income and operational efficiency need to be even more ambitious.

According to the analysis, RoEs of 15% or more will require a TER of less than 60% – which means only the Nordics currently support such conditions  Other countries and regions with the lowest TER include Switzerland and Central Europe. The Benelux has a ratio of 63%, while the UK has a ratio of 65%. Southern Europe has a collective ratio of 87%, with Portugal on 92%.

The consultancy firm concludes its analysis with three measures which could improve the level of performance of European retail banks: (1) cost transformation, which probably needs to account for half of the improvement; (2) higher income per customer, which unlikely will come from higher interest margins and probably has to stem from new services, upgrading of customers and products, and re-pricing of core products like accounts and cards; and (3) strict risk discipline and effective cleaning-up of non-performing loan books.”



The business and operating models of digital-only banks

04 April 2019

In recent years, several digital-only banks have successfully managed to nestle themselves in the banking landscape, with their popularity continuing to increase. Looking at it from the customer’s point-of-view, there is little difference between these FinTech unicorns; looking at the bigger picture, however, reveals significant variation in their business models. Matyas Fekete, a consultant at KAE, explores some of the main similarities and differences in digi-bank business and operating models. 

What about the profit?

Unlike in the UK, in most of continental Europe, bank accounts and corresponding banking services are historically paid-for services. The fact that digital banks offer most of their services free of charge has undoubtedly helped them build a large customer base. On the other hand, despite comparatively low set-up and minimised operational costs compared to that of traditional banks, and given the lack of revenue stemming from the typically no-fee model, profitability has proved difficult to achieve. Monzo, for instance, recorded a net loss of £30+ per customer in its most recent financial year. 

In the start-up world, it is customary to focus on expansion rather than profit – see the case of Uber, for instance. Still, while profitability might not be their number one priority in their early stages of development, it must be a long-term goal of any business. With their ever-growing customer base, digital banks are increasingly under pressure to turn their business from loss- to profit-making. 

Credit where credit is due

Digital banks pride themselves on their fair (often meaning “free”) proposition and have so far stayed clear of offering loans (including credit cards & overdrafts), traditionally amongst the most lucrative products for traditional providers. Though somewhat reluctantly, newcomers are also realising that offering lending products is one of the most straightforward ways to offset losses made on their free, often high-cost services (e.g. overseas ATM withdrawals). Monzo, N26 and Starling have recently started offering credit products to their customers, with their loan offering expected to be extended to a wide range of services, from mortgages to overdrafts. Correspondingly, creating a lending portfolio can also pave the way for launching an interest-paying savings offering – a proposition seen as a basic banking product that is yet to feature in most digital banks’ portfolios. 

The business and operating models of digital-only banks

The premium customer

While most digital banks offer most of their products for free, some have extended their offering by paid-for premium services in order to create a revenue stream. As these premium features – including different types of insurance, unlimited free transfers/withdrawals, faster payment settlement or concierge services – are often offered in a subscription format, customers are typically prompted to pay for the full package rather than just the desired service(s), providing a significant revenue stream for the bank. Revolut, for instance, was amongst the first digital banks in Europe to break even earlier this year, a feat largely due to revenue from its premium subscription.

SMEs like digital too

Traditional banks typically service small and medium sized businesses under their retail rather than corporate banking arm. Having their product offering tested with consumers, and consequently gaining a reasonable customer base, digital banks have also identified SMEs as an ideal segment to extend their target audience to. The five FinTechs profiled have already gone, or plan to go, down this path by following up their consumer solution with a business account. While both propositions are typically built on similar features, some providers charge businesses a monthly subscription (e.g. Revolut), while others apply additional fees to specific services (e.g. TransferWise), banking on the expectation that businesses are more likely to be willing to pay for banking – something they are already used to doing. 

The marketplace model

While most digital banks offer a wide range of banking services, some of these tend to come from partnering with third-party providers. For instance, Starling Bank’s only proprietary product is its current account, which serves as a basis for the provision of ancillary services, ranging from loans to insurance, to investment opportunities. Instead of developing these services in-house, Starling enables a select group of partnering financial service providers access to its platform in exchange for a fee. In effect, Starling is using its customer base to create a market for its partners, charging a commission for each acquired customer. 

In such cases of digital banks applying this marketplace model, the majority of their income often comes from partners rather than customers. Naturally, only banks with a large enough customer base can be successful in this set-up, underlining the current intensity of competition amongst digital banks.

Banking as a Service

While customer-centricity is heralded amongst the main USPs of digital banks, some are looking beyond offering consumer-facing services to diversify their revenue streams. Starling, which is among the few digital banks built on its own proprietary platform, has recently leapt into the Banking as a Service (BaaS) industry, making its technology available to other start-ups looking to launch a digital bank. Naturally, this raises the question whether the two offerings could threaten each other’s success. Generally, as long as such partners operate in different markets, the two business lines should be able to thrive alongside each other. Further along the line, however, such partners could easily end up expanding their banking solution into the same market(s) as they aim for global success, and by doing so, becoming direct competitors. 

Different approach, same result?

It is fair to say that consumers in Europe looking to bank with a digital-only provider would have a difficult time finding relative advantages/disadvantages amongst the leading players in the industry. Still, despite the limited surface-level variety, exploring the business models of leading digital banks reveals different approaches to the challenge of making money. Alongside the more straightforward method of offering paid-for premium features/subscriptions, some are banking on the value that access to their customer base offers to third-parties, while others outsource their technology to neobanks wanting to focus on the Fin rather than the Tech. With competition amongst digital banks heating up, it will be interesting to see which business model(s) prove to be the winning formula in the long term.