European banks hit rough waters in 2016 as interest bites

01 August 2017 Consultancy.uk

Banks across the EU have seen their income per customer fall by 2.6% on average. Profitability per customer meanwhile tumbled by around 5% (excluding Italian banks), as the low interest rate environment continues to negatively affect banks, while cost controls, from branch closures to digitalisation, are barely making up the declines.

New research from A.T. Kearney, titled ‘The Tide of Changes Shifts All Banks’, explores wider changes in the banking system across key European states, as well as the wider background in which the firms have been operating. The global financial system has slowly recovered to reach pre-crisis rates almost 10 years later, following an era of uncertainty in the wake of the 2008 crisis. In Europe too, the slow period of growth in the wake of the crisis has given way to stronger average performances across the various EU states as consumption has increased amid increasing investment.

The global financial crisis saw considerable shifts in overall growth across the European Union on average. Investment fell more than 5% during 2008 before returning briefly to growth between 2010 and 2011. By 2012 however, government were again driving through austerity measures, with consequent drops in investment.

Economic growth in EU

In recent years investment has ticked up, however it remains relatively low compared to pre-crisis years, and net exports growth has turned slightly negative, suggesting there is still some way to go before economists can state a full recovery has been staged. Consumption has increased steadily however, and has returned to pre-crisis levels in a sustained manner. GDP growth, overall, has stabilised at a little over 2% across the EU, however it is worth noting particularly in the UK that wages have continued to stagnate – something that initially caused the credit crunch of 2007, the forebear to the global economic crisis as employees ramped up borrowing to supplement their insufficient wages. In 2014, it was revealed as many as 22% of employees were failing to earn the living wage (not to be confused with the mild improvement of the new minimum wage, which goes by the same name, but is still lower than the living wage).

This suggests that while GDP has stabilised, borrowing at unsustainable rates remain an unavoidable fact of life for many workers. The current monetary policy across the EU meanwhile of excessively low interest rates for a protracted period of time means this borrowing has begun to impact on the profit-making capabilities of most banks across the Eurozone. The decline in net interest income has been slightly offset by a tick up in deposits, up at a rate of 3.3% per annum since 2014, and a slight increase in client loans to businesses, up by 2.6% in the same period, however this borrowing has also been fuelled largely by low interest rates, meaning banks are limited in how much they can benefit from this. There is still clearly a potential for further crisis in this case.

Total income changes

Retail banks have seen operating expenses increase in recent years; while, profit over the four years between 2012 and 2015 increased, costs related to risk provision to bolster the banks against financial market risks, decreased. The most recent result showed a small decline in profit before tax in 2016, while risk provision costs and other non-operative expenses increased by 2 points and 1 point respectively.

Possible decline

The drop in profitability was partly the result of declines in net interest income as well as declines in fee income. The firm notes however, that there has been considerable regional variability in terms of cost and revenue changes. Most regions have invested heavily in the reduction of costs, from reductions in personnel, to branch closures and increased focus on digital channel migration. The cost-to-income ratio has not, however, moved significantly, even given the effort. A lack of adaptation to the low-interest business environment, with past business models focused heavily on interest rate income, noted as a primary causes for the poor profitability outcomes across the region.

Retail banking radar

The research notes that 2016 was a tough year for regional banks profitability. Aside from the cost-to-income ratio increasing to 64%, profit per customer across the region fell to around 150, from 190 the year previous. Net interest rate income relative to total income remained flat at around 70%, while income per customer fell to further to around 630. Income per employee remained relatively robust however, at around 230,000.

In terms of income per customer, the biggest drop was noted in Spain and Italy, at 8.6% and 6.6% respectively, while on average falling 2.6% across the region. Switzerland and Turkey were the regions to see slight growth in their respective income per customer levels. Profitability per customer was down relatively significantly, however, this was largely the result of massive decrease at Italian banks as they scrambled to get their operations into compliance; excluding Italian banks, profitability was down a more modest 5%.

Change of market performance bubbles

The spread of revenue performance was relatively broad in relation to the market position of institutions in 2014. Around 29% of all banks surveyed managed to move from below average to above average performances between 2014 and 2016, the largest segment however (33%), saw their market dominance in 2014 turn into an underperformance in the most recent two years. Around 18% of banks, were unable to turn around their market underperformance in 2014, and have continued to underperform. Around 18% of respondent banks have managed to keep their market overperformance from 2014 into the most recent period.

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The business and operating models of digital-only banks

04 April 2019 Consultancy.uk

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.