The Covid-19 pandemic – one of many drivers of change

The business models of banks were already under significant pressure before Covid-19 forced the global economy to pause. Particularly in Europe, banks had been suffering from low profitability and fierce competition for customers’ business. The combination of these factors has made it challenging for banks to generate enough capital to fund the investments necessary to make the structural changes that are needed to improve the financial sector in Europe.

However, during the global pandemic, banks have proven their value and positive contribution – not only to the global economy, but also to society – by ensuring ongoing funding to businesses and households. The facilitation of public support programmes and economic stimuli would not have been possible without a stable financial sector. However, as the next stage of the pandemic progresses and society moves towards the “new normal”, it will become of the utmost importance for banks to increase their profitability. As we have pointed out earlier, high profitability for a bank allows it to generate internal capital which tends to correlate with a better performance of bank shares. This in turn increases funding opportunities for banks in the financial markets.

To improve the profitability level of the banking sector sustainably, cost-cutting programmes alone are unlikely to be enough, though several banks have focused on this in the first instance. Instead, the creation of new services and products to generate higher income will become a key area of focus. This is not a new challenge for some of the larger financial institutions. Due to low interest rates and the availability of liquidity programmes from central banks, the service of liquidity transformation currently has a lower value in terms of income for banks than before. The impact of Covid-19 is expected to lead to a wave of restructuring, bankruptcies or loan defaults, which in turn will add stress to the balance sheets of banks. However, banks are in a stronger capital position now than at the time of the financial crisis of 2008, and many are well-equipped to seize opportunities coming out of Covid-19.

The additional momentum from the impact of Covid-19 is likely to drive two areas which have been the cornerstones for the transformation of the banking sector in Europe for many years.

First, consolidation of the European banking sector has been a source of much speculation for many years, though it has been a topic for panel discussions rather than board decisions. As banks move towards the “new normal”, many will be assessing opportunities for consolidation through a different lens.

Secondly, whilst the digitalisation of the finance industry has already reshaped banking and financial services during the last years, the impact of Covid-19 is likely to see this become a priority for most financial institutions.

In this paper, we assess in further detail how those two areas might be expected to develop over the next few months and years.

Consolidation of the EU financial sector

Although the overall number of EU financial institutions has continuously decreased since 2008, leading to a net reduction of roughly 30%, the EU is still considered “overbanked”. On a Member State level, Germany’s banks account for almost a third of the banks in the EU, making it the Member State within the EU with the largest number of financial institutions. The European Central Bank (“ECB”) sees a need for further consolidation within the sector but has emphasised that such consolidation should not be driven by bank failures (as was arguably the case for some key M&A transactions in the financial crisis of 2008).

The benefits of consolidation through M&A are well known and extend to transactions within the banking sector. Economies of scale allow institutions to become more efficient and profitable and deploy capital more effectively. For a number of the larger financial institutions, M&A also provides the opportunity to scale-up their technological innovation which can help to build, or support, a sustainable digital strategy in a cost-effective manner. Finally, consolidation helps to reduce excess capacity within the financial sector by reducing the overall number of players.

Nevertheless, M&A within the financial institutions sector is not without challenges. Sellers and purchasers face a challenge to integrate different cultures, IT systems and other infrastructures that have grown (often through historical M&A and “bolt-on” acquisitions) within their institutions over the years. Merger control considerations cannot be ignored, and authorities will want to explore whether the transaction may lead to a lessening of competition or choice from a consumer perspective, in particular where national markets are already concentrated. From a systemic perspective, the risks of an M&A transaction within the financial sector can also be higher than those in other sectors, as a complex (or even failing) integration between financial institutions carries the risk of a greater external market impact (and accordingly increased public scrutiny). Financial institutions are not just interconnected with other financial institutions, but also with businesses of all sizes and with households, which rely on access to their banking systems. Vendors are often also heavily invested in a successful integration, and any failure (particularly of IT systems) can have significant reputational and regulatory consequences for the institutions concerned.

Challenges may also arise from a governance perspective when integrating the leadership team of an acquired entity into existing management structures. Aligning the management of historically, and still legally, independent entities may trigger complicated corporate law issues, including challenges around managing conflicts of interest. Different Member States also impose different corporate governance structures, such as unitary vs. dualistic board composition, which means a consolidation of management structures is often not easily achievable. Finally, there are various national requirements, such as employee co-determination rules, that may result in additional hurdles for any cross-border integration.

Corporate law issues can also complicate the structuring or implementation of an M&A transaction. A typical issue is where only certain business units are being transferred or restructured in the course of a transaction, as the EU-wide regulations on cross-border transformations still have some blind spots. A harmonised regime is available across Europe for cross-border mergers, but an EU-wide demerger regime has not yet been implemented by the Member States. This means that banks are reliant on different regimes (with associated different requirements) at a national level. This often complicates cross-border consolidation efforts and can require complex, multi-step, alternative structures to achieve a similar result.

However, that is not to say that banks should give up on international opportunities as cross-border M&A in the European financial sector is not without its benefits. As an example, the portfolio of the combined institution following a cross-border M&A transaction is likely to be more diversified both from a geographic and product perspective and may consequently become more capital-efficient, increasing the overall resilience of the combined institution.

The consolidation of the financial sector (and in particular, the consolidation of credit institutions) is one of the top priorities of the European regulators and is a particular focus for the ECB. Although the ECB has repeatedly stated that it is not encouraging a consolidation of the banking sector in Europe through M&A transactions, its recent communications clearly indicate that it considers consolidation a key strategy to achieve structural change. The latest development was the publication of the ECB’s draft “Guide on the supervisory approach to consolidation in the banking sector” (“Draft Guide”).

The Draft Guide aims to clarify the principles that underpin the ECB’s approach when determining whether the arrangements implemented by a credit institution post-consolidation ensure sound management and coverage of its risks. Besides setting out the ECB’s overall approach to the assessment of consolidation transactions, it also describes its supervisory approach to key prudential aspects of such transactions. In this regard, the Draft Guide covers the principles for the calculation of the Pillar 2 capital requirements and the Pillar 2 Guidance, the prudential recognition of negative goodwill and the (continued) use of internal models. Further, the Draft Guide elaborates on the ongoing supervision of the newly merged entity to monitor the implementation of the integration plan.

Although the ECB emphasises that it is open to assessing and supporting sustainable consolidation projects, recent consolidation in the European banking sector has generally taken place domestically and among smaller institutions. From a regulatory perspective, the supervisory level playing field within the EU should, in theory, help to facilitate cross-border consolidation. However, the regulatory and legal framework applicable to banks is still fragmented, and restrictions in capital and liquidity rules at a national level make it difficult to move funds freely within cross-border banks or groups. The high level of non-performing exposures in some countries further complicates the valuation of banks or portfolios. It is possible that some, or all, of these regulatory hurdles to cross-border M&A consolidation might be lowered by a further integrated Banking Union.

This challenging legal and regulatory environment, particularly for cross-border M&A transactions, explains why consolidation of the European financial sector has been limited to consolidation at a national level. Nevertheless, the Covid-19 pandemic (coupled with a tightening of margins in a number of more lucrative business areas) is likely to result in a greater need for consolidation. For investors, the management and regulators of European institutions, this means bold decisions in the next few years to navigate the obstacles to a more consolidated European financial system.

Digitalisation after Covid-19

There is a compelling narrative of the Covid-19 pandemic catalysing the digitalisation of the financial industry. In recent years, the digitalisation of the financial sector has primarily been driven by fintech entities which – in approaching financial services from a tech background – challenged the “traditional” banks, investment firms, payment service providers and asset managers, by focusing on specific products or services and providing consumers with a superior digital client experience. The accessibility, speed and lower costs of products and services provided by the fintechs set the digital agenda of the financial sector.

Big Techs like Google, Apple, Amazon and Facebook have also indicated their intention to move into financial and banking services by leveraging their key strengths of technology, data and consumer reach. The emergence of these players within the financial services sector put further pressure not only on the digital agenda of traditional institutions, but also their core business models.

Especially in their retail business activities, financial institutions face the difficulty of maintaining complex IT infrastructure and a widespread network of physical branches (with all the associated costs) whilst at the same time developing ambitious digital agendas. The speed at which fintechs and tech-driven challenger banks were able to design and implement digital strategies and innovate by creating new products and ways of reaching their target market, meant that many (younger) customers moved to the tech-driven challenger banks and fintechs.

The digital revolution has been underway for a number of years; however, the Covid-19 crisis put it into the spotlight. Most retail banks are reassessing how to deliver their services to customers, including an increased focus on online platforms to deliver those services and a smoother customer experience. The broad acceptance of “remote” services offered by the financial institutions by their clients during the pandemic is expected to make it easier for financial institutions to avoid a switch back to their pre-crisis business models involving physical branch access. Many banks will therefore elect to focus the development of their future business strategy around the comprehensive digitalisation of their services. As a result, institutions will have to rethink their business models from a digital / remote service perspective in a manner that also allows the institutions to generate new sources of income (given that current accounts and smaller loans are often not the major profit-drivers within financial institutions). No immediate change to the relatively low profitability for these types of retail products is expected, due to the multiple payment holidays introduced during the Covid-19 pandemic and the likelihood that a low interest rate environment is here to stay for the foreseeable future. However, going beyond the impact of Covid-19 and the question of profitability, one challenge to a purely digital approach for many traditional financial institutions is the need to continue to provide effective and inclusive access to cash for consumers and businesses, which remains crucial for elderly or vulnerable customers.

On the technical side, digitalisation requires the development of new apps and the implementation of new IT systems. In combination with the application of new business models, this will accelerate the need for financial institutions to compete with technology companies which offer payment and other financial services but are more lightly regulated (at least for now). Whether technology companies will continue to be able to defend their comparative advantage of lighter regulation remains to be seen, with an increasing focus by regulators on these types of companies and the question of how to ensure effective supervision of their activities as they grow in size and reach. Antitrust authorities have been actively scrutinising the power and reach of tech companies and this has been extended to payments markets, with the EC having launched a high-profile investigation into the Apple Pay service. Other developments – independent from the Covid-19 pandemic – might also tip the scale towards tighter supervision. The difficulty of supervising complex group structures that include tech undertakings and regulated entities with a high degree of shared services within such groups have become clearer in recent years.

To place further pressure on the need for implementation of new technology on a larger scale, a new generation of fintechs is prepared to transform and chip away at established players. These fintechs have undertaken the labour-intensive process of becoming regulated entities themselves while at the same time operating with state-of-the-art, seamlessly integrated new core banking systems. This allows these fintechs not only to provide users with a superior digital experience, in the same way as the first generation of fintechs have done, but also to undercut banks in their costs for providing their services. For example, Robin Hood in the US and Trade Republic in Germany are offering brokering services free of charge. This raises the bar for established players and increases the need for cost cutting alongside significant investment in their own digital infrastructure.

But the digitalisation of financial services is not only limited to new business models, modern forms of distribution and new IT systems. It also involves the digitalisation of the core processes of banks, such as risk management, compliance or the remote workspace of bank employees. In particular, the last of these developments will require a more comprehensive approach to digitalisation than in the past. To pick up an example from one of our other briefings, if a substantial part of the workforce of financial institutions works remotely, the entire value chain of financial services needs to be remodelled. Or, to put it differently, if a certain portion of an institution’s staff works completely remotely, not only during the pandemic but also after it – a scenario which is being discussed not just within the financial sector – the entire work environment of the financial sector becomes digitalised. Thus, digitalisation is not only a client-facing development but also an inward-facing evolution that will require banks to change their policies and procedures. As for other industries, digitalisation is not only a technical challenge, but more pre-dominantly a cultural one.

Besides its impact on business models and the forced shift to a more digitalised environment in the banking sector, Covid-19 also highlighted the opportunities for new forms of collaboration between not just established financial institutions and fintechs, but also other technology-driven firms. Interestingly, such sector-wide collaboration is also supported by some regulators. As an example, in the UK, the FCA is piloting a “digital sandbox” to support innovative firms (including large financial institutions) in their efforts to tackle challenges caused by the Covid-19 pandemic. Areas of focus will include preventing fraud and scams, supporting vulnerable customers and improving access to finance for SMEs. This “digital sandbox” aims to provide a digital testing environment that will facilitate innovation in the financial sector. The approach is founded on features like access to high-quality data assets, a collaboration platform, access to regulatory support and an observation deck which allows regulators and other interested parties to “observe in-flight testing”. Firms should be mindful of antitrust principles in any collaboration between competitors, even if endorsed by regulatory bodies.

This approach underpins the view that the Covid-19 pandemic has facilitated a new chapter in the digitalisation of the financial sector, by pushing the established financial players to think about digitalisation from a more holistic perspective. Simultaneously, challengers who have not created a clearly defined competitive advantage, such as superior technology, have started to see funding and customer support dry up. And the Covid-19 pandemic may provide the unique opportunity for the traditional institutions to challenge the challengers.