Changes triggered or accelerated by the COVID-19 crisis are catapulting banks globally to reassess traditional products and reform strategies and business models. This article takes an exhaustive look at some of the trends, challenges, and opportunities for banks in the post VIVID world.
According to current banking theory, the banking functions can be sorted into three categories - one is maturity transformation and liquidity (loans with long maturities that usually have high interest rates and short term deposits or liabilities of a bank). Second is managing information and examining borrowers. And third, retail and wholesale payment services. Different revenue streams for banks include interest income (through retail facing products e.g., FD/RD, debit, or credit card services), capital market gains (though business/commercial/investment services), and the most stable form of income specially during economic crisis is fee income (e.g., banking account maintenance fee, credit card fee, etc.)
Challenges in the pre-COVID era
In the pre-COVID-19 era, the banking sector was already dealing with several challenges. The banking business models were hampered by a perfect storm of low economic growth and low interest rates, rising compliance costs, and rising competition from digitally enabled agile fintech companies. A low interest rate environment (LIRE) which saw a huge gap in interest rates on deposits that lead to reduced profitability.
Stringent capital and liquidity regulations require banks to maintain more liquidity, them reducing their capability to lend. Rapid digitalization with the emergence of technologies and new players has reduced the costs and improved the quality and accessibility of various services. This downward stress on fees and prices and squeezed margins have further impacted profitability.
Even before the pandemic hit, digital banking had already surpassed personal banking where an individual would visit the branch to carry out any banking activity. Many traditional banks have struggled with digitalization for today’s tech-savy customer.
The percentage of consumers using two or more digital payment methods was 45% in the US. From 2015 to 2019, the growth rate of total digitally active banking customers (online + mobile) was around 3.3% year-over-year. Similarly, from 2015 to 2019, sales growth for major digital products averaged 2.7%.
The dawn of a new era, the new normal
The post-corona world brought new challenges and opportunities in the form of large corporate and household defaults and associated bad debts, prolonged periods of low interest rates, and a hyper digitalized world. While banks got temporary regulatory and supervisory relief by most governments, digital banking adoption has doubled during the pandemic.
The innovation in Payments technology coupled with digital money has challenged traditional banking models. Cryptocurrencies and related blockchain technologies have become a natural solution to the new demands for alternative digital assets beyond traditional custodians. Money can be stored in any form of trusted database (digital ledger).
The COVID-19 pandemic has accelerated the trend towards digital payments. This hyper-adoption of digital communication and related business processes will leave a lasting impact on our daily lives, especially payment processing.
Banking in the post-COVID world
COVID-19 has already begun to accelerate some existing trends in the banking sector, temporarily reverse traditional processes, and influence major players in the sector (including the regulators). COVID-19 has indirectly deepened and lengthened the period of low or negative interest rates and accelerated digitization and increased investment in technology, especially with high operational risk and cyber-threats. It temporarily increases NPLs, curbing profitability, impairing capital generation capability of banks, and buffer and constrain their capacity to provide loans.
Digital transformation is accelerating, new risks are emerging, and banking models are under pressure and reputations are at stake. The COVID-19 crisis has created a lot of pressure on banks to improve their technical capabilities at a time when they are also more vulnerable to cyber-attacks and consumer credit challenges.
In the pre-COVID-19 world, banks were struggling with low interest rates, the legacy of the global crisis with high NPLs, new competitors and digitalization and a more stringent regulatory burden. In the post-COVID-19 world, these challenges have intensified, with only temporary alleviation of the regulatory burden due to the impending crisis.
The massive expansionary fiscal policies that were adopted by many countries to limit the damage from the crisis and therefore indirectly help the banking sector, will lead to significant increases in debt-to-GDP ratios (The average debt-to-GDP ratio increased by 20% in 2020 alone).
Here are some trends of the post-COVID era:
- Digital disruption from platform companies: Fintechs are matching with banks in valuation, having already captured 3 to 5 percent of banking incomes in the US and the UK markets. They have engaged customers in their daily lives to solve definite financial needs with a typical experience while extracting valuable customer insights with progressive analytics. These digital companies have gained customers by the millions and a rapt audience of investors are attracted to their compelling growth story. In the United States, roughly 40 percent of retail clients are already banking with a big tech. In Western Europe, this invasion is at 30 percent. The main reasons to bank with fintechs are fee and customer experience—more precisely easy access, speed of service, and app features. Amazon, Apple, Facebook, and Google have consumer payments options; some offer credit cards, and most have point-of-sale (POS) consumer finance options. In China, Alibaba and Tencent have wider range of offerings. Stakeholders are putting their money in alignment with buyer preferences. In 2020, total investment in fintechs reached about $40 billion globally. In the first half of 2021, fintechs raised $52 billion. These might be considered small-ticket investments compared with global banks’ market cap of $8 trillion. However, the threat for banks is not how relevant fintechs and big techs are today but how rapidly they will grow and shape themselves to match the customer needs in the most lucrative parts of the financial-services business. What matters is that these companies are resetting customer expectations.
- The cyber risk landscape is evolving: Bank leaders face the complicated task of stabilizing the conventional approach to risk management with the need to react immediately to a crisis that has created major changes to their operating environment. Many criminal cyber activities including credit card frauds and phishing attacks have increased substantially, remote working becoming the new norm.
- Regulation, policy, and financial stability: The digital interference in banking raises regulatory issues in at least the following domains: micro-prudential, macroprudential and competition policy, consumer protection and data management.
The industry has started operating almost entirely remotely overnight in a manner of speaking. Online banking, remote working, e-commerce, and electronic payments are on the rise and these trends are here to stay. This massive and sudden increase in digitalization channels entail a significant increase in operational risk – cyber risk in particular – that will require banks to make appropriate adjustments to their risk management functions. The banks that can react quickly will take advantage of more advanced technologies compared to before the crisis, but they will face the threat of Fintech and BigTech competitors in some segments of the business.
The rapid shift towards a hyper-digital world because of the confinement policies in response to COVID-19 is a reminder that the speed of change may take the sector (and everyone) by surprise. This change may also speed up the adoption of different forms of digital currencies and may put the focus on the introduction of central bank digital currency. BigTech companies have all the ingredients to get ahead, in general in the post-COVID world. They have the technology, customer base and brand recognition, as well as access to vast data and deep pockets. They also have the incentives to get into financial services, as discussed before.
Post-COVID-19, banks might have the upper hand in funding, through deposit funds and large balance sheets, while BigTech has a higher cost of capital. Furthermore, banks are now back at the center stage of the intermediary chain as lenders to the real economy. Banks will distribute direct support and credit (typically with partial public guarantees), or both, with the backup of the central bank. They also enjoy the protection of the safety net, with a low volatility of deposits. All these factors give them an edge overshadow banks and new digital entrants. While all financial institutions will suffer the consequences of this crisis, policymakers will tend to focus on saving the banks, where most deposits and lending takes place.
The financial intermediation sector will face deep restructuring, accelerating the pre-COVID-19 trend, with medium-sized banks suffering since cost efficiencies and IT investment will be crucial in a persistently Low Interest Rate Environment.
The future is "bankable."
The world economy has fared far better than expected and so have the banks. The economy is weathering the pandemic and has exceeded pre-COVID (2019) levels on most metrics. Capital markets, corporations, and consumers are showing flexibility in all the regions. The speed of improvement varies by region, with China and the United States in the lead , while Europe is still further down pre-COVID-19 levels in GDP, industrial production, and private consumption.
Success has many parents:
- Greater economic stimulus with governments supplying economic growth worth about 17% of GDP, a far cry from the 1.5% they provided after the 2008 global financial crisis.
- The world was not ready for the exceptional speed of vaccine delivery by the scientific community who has created several vaccines in less than a year—a process that usually takes decades.
- Resilient business have fundamentally reinvented their products in an agile way. Ecommerce has grown from 18% of all retail sales in 2019 to 29% in 2020. The pandemic has also provided tailwinds for the food tech and payments tech sales around the world.
- Credit moratoriums allowed for breathing space for SMEs to recover from initial demand and supply shocks that impaired the ability to repay loan.