European retail banks were facing numerous challenges before the Covid-19 pandemic hit and are under even more pressure now. As James King reports, they will need to embrace change if they are to survive.

ECB

Even before the onset of the Covid-19 health crisis, a range of difficulties were stalking Europe’s retail banking landscape. Mounting regulatory pressures, low to negative interest rates, the growing presence of digital challengers and unfavourable demographic trends, among other issues, were mapping out a bleak trajectory for the region’s retail and savings institutions. The arrival of a global pandemic has exacerbated many of these challenges, while introducing a set of new problems that will snowball over the next 12 to 18 months. As a consequence, seismic market changes sit on the near-term horizon. 

For now, the Covid-19 crisis sits at the forefront of most banks’ immediate concerns. According to its 2020 European Retail Banking Radar report, the consultancy Kearney expects retail banking revenues to drop by 20% in its base case scenario, though in some cases this could be as high as 35% to 40%. This is based on the fact that consumer spending across the region has collapsed as a result of national lockdowns, while various payment holidays, on mortgages and loans, have coincided with the lifting of some fees and the expansion of credit card limits.  

These dynamics have, according to Kearny’s research, “left banks in a precarious position as their income levels drop, while operating costs remain relatively unchanged”. To compound this dilemma, Europe’s retail lenders are bracing for a wave of non-performing loans (NPLs). The European Central Bank (ECB), in research published in May 2020, analysed 88 different banking crises since 1990 to see what lessons can be applied to the Covid-19 pandemic. The conclusions are worrying: only in one-fifth of cases did the ratio of NPLs to total loans, across the featured banking systems, stay below 7%.

Notably, the ECB’s research indicates that NPLs tend to spike long after a crisis has occurred, meaning the real pain for Europe’s retail banks is some way off. For many European economies, particularly those most afflicted by the pandemic, wide-ranging government support measures have offered needed life support for workers and businesses alike. But as these programmes unwind, the pandemic’s real economic devastation will be revealed. For retail and savings banks, in particular, this will not be easy. 

Lower for longer

Under these conditions, there seems little chance that the region’s low interest rate environment will change. “Prior to Covid-19, there was a possibility that interest rates may have bottomed and that the environment might have started to get better for the banks. But the pandemic has been a huge deflationary shock, and so rates are going to stay low. That’s going to be a major headwind for the banks,” says Edward Knight, a partner with global venture capital and startup generator, Antler. 

Indeed, the Bank of England cut its base rate from 0.75% to 0.25% on March 11, 2020, before slashing it further to 0.1% on March 19, its lowest level in history. In the euro area, the ECB’s deposit rate has been set at -0.5% since September 2019, while the reference rate set by Sweden’s Riksbank currently sits at 0%. Europe’s retail and savings banks have been hurting, as a result of this environment, for some time. But the Covid-19 pandemic has shut out any chance of relief in the coming years. In light of this challenge, adaptation offers the only way forward. 

“We are going to have to adapt. We are suffering as a result of lower net interest margins, but savers are suffering even more,” says Chris De Noose, the managing director of the European Savings and Retail Banking Group (ESBG). Indeed, the pandemic has accelerated a move towards market adaptation that has been gathering momentum in recent times. In common with dynamics across the wider banking industry, this concerns the drive towards digital transformation. For retail and savings banks this process is principally focused on cutting costs. Since 2007, 61,000 branches, as well as 600,000 staff, have been cut from the operations of European banks, according to Kearney’s research. 

But as this research notes, most of these cost-cutting measures represent the low-hanging fruit. Looking ahead, a more systemic degree of cuts and changes will be required to transform bank operating models, so that customers can be served in different ways, while new methods of working are also enacted. Kearney estimates that cost reductions, to the tune of 20% of the cost base, will have to be achieved in order for banks to progress through 2021 and beyond. 

Silver lining

The good news for the banks is that the pandemic has moved the dial on customer preferences and behaviour. As a result, a profound migration to fully digital channels is taking place. Research from Boston Consulting Group published in May 2020, points to the fact that 24% of UK bank customers are planning to use branches less, or stop altogether, while both Singapore and Italy registered more than 50% increases in the use of online and mobile banking channels. From a retail banking perspective, it is clear that institutions will have much more latitude to pursue far-reaching changes to their operating models.

“What we have seen since Covid-19 is a massive increase in the use of digital channels. And I am convinced that this growth in digital engagement is here to stay. In some ways, it represents an inflection point in terms of people interacting with their banks in a different way,” says Afonso Nascimento, partner and managing director, financial institutions with BCG. 

As part of this business transformation, Mr Nascimento believes that retail banks will need to move beyond simply servicing their customers through digital channels. “For me one of the key things in the future is who is going to master digital sales. A lot of investments have been made in servicing clients, but now that branches will contribute even less to the customer experience, the question becomes who can generate sales from their digital offering?” 

The difficulty here is that the position of the continent’s established retail and savings giants is being threatened by successive waves of digital challenger banks, as well as fintech groups. These are digital-native entities with low operating costs and excellent customer facing products and services, which boast an array of functionalities that are typically absent from the offerings of legacy institutions. These challengers are pushing ahead with innovations to cater to mostly younger and digitally-savvy customer segments.

“I think it’s clear that lots of incumbent legacy business models in every industry, not just banking, are being rapidly chipped away at, and eroded by, the innovations that come with software and the needs of younger people to find solutions to their everyday problems,” says Mr Knight.

For the retail banking sector, this has contributed to enhanced digital offerings from these challengers relative to legacy institutions. Customers of Revolut, a digital-only banking app, are offered frictionless currency exchange options alongside the ability to purchase a range of cryptocurrencies, including Bitcoin, Ethereum and Litecoin. “The winners of the drive towards digitisation have been the challenger banks because they understood the shifts sooner, and they simply offer more functionality on their platforms,” says Mr Knight. 

Light and nimble

While these trends aren’t new, the fallout from the Covid-19 pandemic has accentuated the differences between digital challengers and their legacy banking peers. Notably, it has underscored the operating cost differentials of both systems, while highlighting the benefits of having a light physical footprint, low staff count and nimble operating model at a time when costs are skyrocketing and customers are choosing – or being forced – to engage with financing services through digital means.

In this regard the story of Illimity, which bills itself as Italy’s first digital-native bank, is instructive. Established in 2018, the lender has swiftly secured a foothold in Italy’s banking market across the three domains in which it operates: direct banking, small and medium-sized enterprises and distressed credit. But it is the speed with which the bank was established, as well as its reaction to the Covid-19 pandemic, that are the most striking aspects of its story. “Everything has been developed on a digital, cloud-based infrastructure. This enabled us to build the bank very quickly; in less than a year, Illimity was up and running,” says Carlo Panella, head of direct banking and chief digital operations officer at Illimity. 

In the early months of 2020, as Italy’s health crisis was escalating, Illimity was able to switch to remote working with lightning speed. The bank’s cloud-based architecture, coupled with the fact that all employees are equipped with company laptops and mobile devices, meant a shift to full remote working was effectively seamless. “Illimity’s shift to remote working, as a result of Covid-19, took less than six hours,” says Mr Panella. 

Beyond this flexibility, however, Illimity’s development has been focused on open banking. As a result, customers can initiate transactions with five different current accounts through their Illimity app, while partnership agreements with both financial and non-financial service providers mean that an entire ecosystem of functionalities are on offer through its app. “We had the opportunity to focus exclusively on building a digital bank, not on transforming an existing bank. Illimity is designed around the Payment Services Directive 2 regulations and open banking [because we believe] the future of retail banking innovation is going to come from interactions with third parties,” says Mr Panella. 

Time to transform

While it seems clear that digital challengers, such as Illimity, are shaking up Europe’s retail banking landscape, and that this process is being accelerated by the Covid-19 pandemic, legacy institutions are also taking steps to prepare for this future. CaixaBank’s mobile-only offering, known as imaginBank, which caters to younger customer segments, relaunched in June 2020 as digital services and lifestyle platform ‘imagin’. As a result, imagin will harness a full suite of financial and non-financial digital offerings for the benefit of its 2.6 million customers. 

The drive by many established retail and savings banks to launch their own digital offerings, and adapt to the changing market, can only be a good thing for consumers. But, as Mr De Noose from ESBG indicates, the drive towards digitalisation must be accompanied by education. “A lot of people are not used to digital banking. This means we have to educate them, not only educating them in financial services, but also digital financial services. It’s one of the roles that we have to fulfil.”

Indeed, as retail banking assumes an increasingly digital dimension, it will require a fundamental rethink of the ways in which bank staff are trained and interact with the customer base. This will come with costs but also a number of opportunities. “There will be opportunities in terms of banks engaging with customers in a more cost efficient way. If banks do this well, they will be able to expand their client base. They can also use this period to reskill their employees and to rethink the future of their business,” says Mr Nascimento. 

Uncertain future

Looking ahead, both digital-only banks and their legacy peers are set to face a sustained period of uncertainty. For one, the full impact of the Covid-19 pandemic is difficult to predict, and may take a number of years to unfold. But perhaps more importantly, Europe, as a region, is facing a number of existential challenges over the longer term. This includes a simultaneously shrinking and ageing population, which is likely to contribute to longer-term economic decline. Navigating a path to sustainable growth in these conditions will be a difficult task. With household debt levels across a number of markets already relatively high, opportunities for growth will be limited in the coming years. Retail banking, therefore, is in need of a revolution. 

“In their current configuration and with their current strategies, it’s hard to see how established retail banks can reverse their decline,” says Mr Knight. 

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