Category: Bank

Categories
Bank Economical policy Euro zone Finance

Institut Messine – Thoughts on an economy with negative interest rates

SUMMARY

Acknowledgments

Foreword by Michel Léger

General introduction to the issue of negative interest rates by Michel Aglietta and Natacha Valla

Robert Ophèle, Deputy governor of the Banque de France

Maya Atig, Deputy CEO of the Agence France Tresor’s

Jesper Berg, CEO of the Financial Supervisory Authority of Denmark

Philippe Capron, Deputy CEO of Veolia, in charge of finance

Jean-Jacques Daigre, Professor emeritus of Banking and Finance Law

Ramon Fernandez, Deputy CEO of Orange, in charge of the group’s finances and strategy. Ramon Fernandez was previously Director of the Treasury and President of Agence France Tresor’s

Marc Fiorentino, Founder-Director of Euroland Corporate

Hervé Hannoun, former Deputy CEO of the Bank for International Settlements

Philippe Heim, Chief Financial Officer of Société Générale

Denis Kessler, CEO of SCOR SE

Olivier Klein, CEO of BRED, Professor of Financial Economy at HEC

The point of view of Olivier Klein*

What is your opinion on the conceptual complexity of negative growth rates? As a banking “boss” and Professor of Economics, did you ever think you would ever experience such a situation?

The very concept of negative rates rather worrying and so specific that I never thought I’d ever have to deal with it. Certain economic players are adapting quite well to it: some of our institutional customers are now investing money with us at negative rates. They prefer to place it with us at -0.15% rather than at -0.20% elsewhere[1].

Negative rates can be explained by the current macroeconomic set-up. The European Central Bank (ECB) is trying, with these negative rates, to find a balanced level of savings-investment which is more conducive to growth to ward off what some people are describing as the threat of secular stagnation. But this is also “just” an adjustment period after a phase of excessive debt as has often been observed since the 19th century after financial crises. In any event, what the ECB is trying to encourage agents not to just let money sleep and invest and encourage banks to extend credit, but also to encourage debt reduction, by maintaining low rates compared to the nominal growth rate.

The use of negative rates is currently limited to the field of transactions between institutional and financial professionals. This is not yet the case for businesses in France – whereas businesses are also beginning to deposit at negative rates in some European countries.

It also affects a very material limit of the capacity of the system to pass on lower rates throughout the economy: neither the banking system, which needs deposits to make loans, nor the authorities, for fiscal and security reasons, can afford to neglect the appeal that cash could have, especially for households, as an alternative to negative interest bearing deposits. France seems to be relatively preserved from this risk compared to countries like Germany, where the cash culture is much more developed.

Why do you think that there was a need to introduce negative interest rates in the euro zone, while the United Kingdom and the United States, which have nevertheless resorted to unconventional policies, have not had to introduce them?

I believe that this can be explained by the existence of a risk of deflation that is greater in the euro zone than in the United States, that the ECB, quite rightly, wanted to ward off. One reason is the crisis in the euro zone, which led to a second economic downturn just after the 2008 crisis, due to the incomplete nature of our monetary union which creates a slight “deflationary bias”. It is also possible to invoke the lesser impact of the “wealth effect”: in the United States, lower rates quickly led to a recovery in asset values,especially the stock market, which resulted in a reconstruction of the value of household savings – which is, across the Atlantic, much more invested in the markets because of the importance of pension funds. In all, it was necessary to hit even harder on rates in the euro zone. But it is a quantum issue, not an issue of principle: the ECB did not enter into negative territory just for the sake of it, but to cut rates as much as needed, and the Bank of England and the Federal Reserve did not remain in positive territory to avoid negative rates, but because the zero rate was sufficient in their respective cases.

How is the profitability of retail banks impacted by the environment of negative interest rates?

We have to distinguish between the effect of interest rates which are decreasing and that of negative rates. Structurally speaking, banks lend long-term and refinance short-term. In general, as we lend in France, at fixed rates, in the very short-term there is less hysteresis in bank liabilities than in assets – in other words, if rates fall at the same pace for all maturities, the cost of a part of our resources immediately decreases, whereas the product of loans only decreases over time, as our loan portfolio is gradually renewed. An homothetic drop in the rate curve will therefore play in favour of the banks in the first year. Nevertheless, this situation is only temporary, because very quickly, the portfolio entry of new loans granted at lower rates and the amortisation of old loans at higher rates, but also the mortgage renegotiation requests made by private customers, cause a decrease in the rates of our assets which is faster than that of our liabilities, that contain a lot of resources indexed at regulated rates which vary less rapidly. This brings us to a deteriorated intermediation margin rate, but in an acceptable and manageable quantum. Then, eventually, when the rate curve stabilises, if the slope of the curve remained constant, the net interest margin will gradually recover.

What is happening today is different. First of all, the net interest margin is compressed, through the evolution of the differential rate between the long and the short rate, that is to say the slope of the rate curve. For the last two years, central banks have indeed been looking to govern and bring down not just short rates, which they always set more or less directly, but also, which is new, long rates, through policies of quantitative easing (QE) and by clever management of agents’ expectations in the context of forward guidance. This policy works well, leading to a compression of the rate curve, and thus of the interest margin of banking institutions.
Negative rates introduce an additional element, which is frustrating for our business model. Since, for the most part, we do not pass on lower rates below zero to our depositors, the falling cost of our resource comes up against an obstacle.

In summary, the product of our loans, correlated with falling long rates, decreases, while our refinancing has a cost that can no longer decrease in parallel with it, considering the impossibility of getting the bulk of the interest paid on deposits into negative territory. The rate slope is therefore compressed even more. It is easy to see that this situation is very unfavourable for the profitability of our institutions. Our net interest margin, which was able to reach almost 6% in the early nineties, has been levelled off at 2% for years and since 2014-2015 we have entered a further phase of gradual decline, which is going to further accentuate in the next few years, with the amortisation of our old loans at higher rates and the entry into force of new loans at very low rates.

This development will be lasting, and banks must resign themselves to surviving for quite a long time in a context of very low interest margins: the movement cannot, in my opinion, be reversed for at least two or three years since the “renewed steepening” of the rate curve will only take place just in time, given the low potential growth rate of the Euro Zone, and its beneficial effects for us will only be felt through the renewal of our loan portfolios. The very specific monetary conditions we are experiencing – negative rates and QE – seem genuinely welcome to me in terms of the general economy: the ECB had no other choice. But we must be aware that they are specifically unfavourable to banks… But also to insurers, pension funds and all those who need a return on their assets to be able provide the services expected of them.

Are banks therefore being forced to seek new sources of income?

There is no doubt that the decline in interest margins that I have just mentioned has caused us to diversify our sources of income. Of course, the banks can first try to compensate for the erosion of margins with a volume effect on outstanding amounts, but we cannot go very far in this area: either we try to gain market shares – which, by definition, not everyone can do at the same time – or the banks, as an aggregate, rely on the general expansion of the volume of loans in the economy – which is highly seasonal due to the low level of growth.

Banks, if they are considered as an aggregate, can therefore think about playing on higher commissions, that is to say, looking for better and fairer billing for their services. Indeed, we have seen a slight shift in this direction in the past few months. But once again, it’s not as easy as people often imagine.

First of all, the supervision of our activities by the various consumer protection mechanisms limits the opportunities. But, in addition, there is keen competition which does not give much leeway. Furthermore, the context of low interest rates hangs over certain types of commission. It is understandable, for example, that “placement commissions” in the field of life insurance cannot be the same in a context in which contracts make 2.5% or 3% as when the standard remuneration for savers was 5% or 6%. The same applies to asset management. We can therefore see, with many products, our commissions fall progressively with falling interest rates.

The new services still remain. My feeling is that their spectrum is limited by the objective needs and expectations of customers with regard to their banks and through the necessity of maintaining a coherent and fair offer. So we would not seem to be very legitimate as a travel agency or computer salespeople, for example.

That is why many players, who are unable to increase their revenues to offset the erosion of interest margins, are now trying to reduce their operating costs, such as by reducing the number of bank branches. A new, more financial argument now needs to be added to the “technological” argument – the usefulness of branches is eroding since customers are using our digital platforms more and more intensely: if we cannot remunerate the conversion of deposits into loans by a sufficient margin, the cost of large networks of branches becomes prohibitive. If this vision, which I do not necessarily agree with, was to prosper over time, thousands of jobs would potentially be at stake in retail banking. So we can see that the operational impact of the monetary context we are discussing is not negligible! So although there are potential strategies for “coming out on top” for specific banks, the industry as a whole is doomed to have to deal with real profitability difficulties.

Is the compression of returns also forcing banks to take more risks?

You might think so, but this is not the case. The new prudential regulations in fact leave less and less room for taking risks[2].

What are your specific thoughts on the role of prudential ratios in the context of low growth and very low, or even negative rates, that we are currently experiencing?

As a banker and professor of economics, I have long been convinced that it is necessary to implement prudential rules and macro-prudential policies for the simple reason that markets do not self-regulate themselves – this was highlighted in many theoretical contributions, but above all, unfortunately, in practice, with the crisis of 2008. Finance is intrinsically procyclic. The potential for regulation therefore plays a crucial role in avoiding financial instability as much as possible.

But it turns out that the prudential standards put in place since the Basel 2 agreement, which are well founded on many points, also incorporated a problematic procyclic character. The risk calculated by RWA (Risk-Weighted Assets), based on historical measurements, with equal volumes of credit, in fact lowered during the euphoric phase of the cycle, which, all things being equal, made a rise in the leveraging effect of banks and the accompaniment of the increase in the general demand for credit possible.

This then promoted the build up of weak financial situations for both households and businesses, in a context in which the euphoria specifically led borrowers and lenders to underestimate the risk. By the same token, at the time of the turnaround, the established risk reappeared in bulk in the books of banks, which naturally weighed on their willingness to lend, but in addition, the constraints of prudential ratios stretched because the increase in the cost of the risks recorded resulted in a rise in RWA through an equity shortfall, thereby leading to an even stronger decrease of the capacity to lend. This method of banking regulation could then encourage the formation of bubbles, then their bursting, and accentuate the financial cycles. It was therefore necessary to rebuild them, which is what Basel III did, particularly through creating a countercyclical capital buffer.

Are prudential measures also a risk factor, as they contribute to creating a type of bond bubble, particularly with government Securities?

Banks have progressively been faced with a tightening of regulations with stricter solvency ratios since Basel 3: they are being asked to hold more equity for the same RWAs and the weight of the risk in calculating RWAs is stronger than before, especially for loans to businesses or for market risks. In the case of a stronger upturn in the economy, this could be a risk of the insufficient capacity of the banks to support the recovery. Furthermore, the liquidity ratios undeniably favour the fact that banks are investing in sovereign bonds.

Do you mean that the prudential regulations are ultimately leading to credit rationing for businesses?

Up to this time, people have really been wrongly accusing the banks in France. There has been no credit rationing to businesses, and the Bank of France and ECB indicators clearly demonstrate this. Let’s go back to the course of the seven years that have just passed. Much of the decline in the distribution of credit seen in the years following 2008 can be explained by a lower demand for credit: businesses cut their investment spending and borrowed less, because of the changing unfavourable economic conditions which they were facing and their lack of trust in the future. Even today, however, very low, or even negative rates, are not enough alone to make people want to borrow.

It is true, however, that when the real economy was on the ropes after the financial crisis, we were able to observe, for some months, less of the general reluctance to lend that the banks were accused of and greater selectivity, which is, for that matter, is perfectly understandable. Not lending to businesses whose future is seriously compromised is a part of the normal role of banks. It is an economic function of the profession, that it must fully assume: if banks do not fully exercise “monetary restraint”, granting loans to businesses that were destined to disappear, they would generate distortions in the markets of their customers and harm the proper development of other businesses that are healthy and sustainable.
We have now left this period behind. However, with the new liquidity and solvency ratios, it will now be progressively more difficult for banks to follow a trajectory of the demand for credit which would improve significantly.

Why do we find ourselves in this situation, even though the objective of the political and monetary authorities is to facilitate granting credit by any means to promote growth?

The truth is that banks were considered as being at fault for the crisis, which is, in my opinion, a vision that is at the very least fragmented, and doubtlessly false in Europe in any case, even if we can argue that they were inevitably a factor in spreading the crisis. As such, we are now in a post-crisis historically conventional phase of “financial repression” of indebtedness, marked by very low interest rates and tougher demands placed upon banks: we are saying that we must “avoid this” at all costs in the future. This concern is reflected in a number of new or tougher regulations, at the very moment when, in fact, a monetary policy aimed at reviving credit with the use of novel instruments, just like negative rates or quantitative easing, is being mobilised.

The most paradoxical thing is that, although they are aware of this contradiction, central bankers now seem, in order to get out of this, to be inviting the development of disintermediation and securitisation, which were held up to public obloquy a few years ago, purely because of the role they actually played in the accumulation of bad risks in the United States, which ultimately led to the crisis. So we are now seeing hedge funds, assets managers, insurance companies, mutual health organisations and pension managers lending to businesses, even though they do not have the historical expertise of the banks to do. There is a considerable asymmetry of information between these new lenders and those to whom they are lending. Some of them, such as hedge funds, are also barely regulated or not regulated at all.

Should we not, however, be pleased to see that some businesses, particularly some great intermediate size companies, finally have access to the market, particularly through the development of the Euro PP?

In theory, yes. My feeling is, however, that we need to be very careful, because not all medium-sized companies can effectively withstand such financing without endangering themselves, especially because of the depreciation method for such loans. Banks usually ask small and medium enterprises to make one annual repayment by providing them with depreciable loans. This is sound practice: the company therefore knows that it must dedicate part of its annual cash flow to repaying its loans and monitoring its management ratios. Euro PPs are very different because, by using them, businesses can be financed for as long as five years with bullet loans. The system is even more attractive today as both rates and spreads are very low.

In the case of large companies, which issue bonds as part of high annual issuance programmes, financing with bullet loans is in some ways similar to a redeemable loan, since we can see a kind of an amortisation schedule: if, for example, the average horizon of the bonds issued annually is seven years, then 1/7th of the outstanding borrowings must be repaid each year. However, only certain types of medium-sized companies are able to issue Euro PPs on a regular basis. Most therefore create a unique and extended due date ahead of them, which effectively means that when the time comes, they may find themselves facing a wall of debt that they can only overcome if they are able, at that time, to re-borrow the full amount of the loan that they have to repay all at once. There are two disadvantages: firstly, nobody knows what situation the company will find itself in that time and, secondly, over the duration of Euro PP, the cashflow constraint was lifted for it – which in some cases could be crime-inducing.

you mean that only the banks are capable of distributing credit without taking or running undue risks?

I quite obviously believe in the usefulness of banks and market financing coexisting! But I don’t think that the market is suitable enough for smaller companies. The role of banks cannot be reduced because banks have a good knowledge of borrowers and because they keep the risk on their balance sheets, which brings them, in their own interest, not to lend any old how and to “monitor” their customers over time.

We also know that, in the United States, securitisation was one of the factors that facilitated excessive indebtedness in the early 2000s: banks were partly responsible because, by not keeping risks on their books, they were less selective about borrowers and did not “monitor” them afterwards. There is a major problem of incitement to selection in market financing as soon as we leave the case of very large borrowers who can, through credit rating agencies, as well as through a lot of communication on their own situation, afford the cost of financial reporting, thereby reducing the asymmetry of information. This intrinsic fault in securitisation has partially been corrected by some of the Basel 3 provisions, which requires banks to maintain a quota of risks associated with the loans that they securitise.

The momentum towards greater disintermediation that we are currently experiencing could be a factor for increased financial instability, while bank credit itself is a factor of stability if it is properly regulated. In my opinion, the share of banking intermediation determines the level of stability of a financial system as a whole. Indeed, banks do not just mobilise savings to serve investment: these are centres of risk. They take counterparty risks in the credit act and interest rate and liquidity risks in the conversion act upon themselves (converting short maturity savings into longer maturities with average credit). Risks are not created by the banks, but managed by them, so that they provide relief to the economy. They manage them carefully, professionally and in a regulated environment. Markets are useful to the economy, but they leave interest rate credit and liquidity risks to lenders or borrowers, which is quite different!

By increasing the share of disintermediation, we will not reduce the risk, we will move it to a multitude of players that are less well equipped than the banks to manage it. The issue of the proportion between banks and markets, between intermediation and disintermediation, is therefore crucial for financial stability. Just like the quality, relevance and scope of the prudential regulation itself, which are also highly crucial.

However, as you said earlier, sociological and technological developments on the one hand, and the monetary context on the other hand, seem to be threatening the very purpose of banks, on the consumer market at least. Will the retail banking business model survive these shocks?

There are undeniably profound changes to our activity. This invites us to return to the economic constants that justify our existence, while ensuring the changes needed to take account of the “customer revolution” caused by the technological revolution. Private customers have, and will always need, a reliable and professional advisor to talk to them about their life plans and advise them about their main loans – with property leading the way- their savings, their retirement protection… But private customers now require greater convenience in their relationships with banks, such as with the strongly developing use of the Internet and Smartphones. They also want greater relevance of the advice that is given to them. But they still want to have access to a qualified contact person who knows them when they have to make important decisions. Building on human capital, giving more convenience and greater added value to banking advice, while using the technological revolution for both the use of its customers and to redesign their own organization, is certainly a crucial industrial and human challenge in retail banking that must be addressed quickly.

[1] This interview was conducted in November 2015.
[2] The new prudential rules prohibit banks from “playing” on markets with their own funds.

Categories
Bank

“Banking and new technologies : the new reality” ; published in La Revue d’Économie Financière, december 2015

New technologies create a new relationship with the world for everyone. A new way of thinking about time and space. Another way of designing information, knowledge and autonomy of action. In fact, they induce a series of revolutions, in both our daily lives and business.

Download the article

Categories
Bank Management

How are new technologies transforming customer relations?

It’s a sociological fact that new technologies have changed our lives. What has been the impact on companies?

Olivier KLEIN: It cannot be denied that new technologies have redefined the world order. They have given rise to a series of revolutionary chain reactions in our day-to-day existence, and especially for companies. The first is a commercial revolution, one which has transformed the balance of power between producers, sellers and consumers. It comes from power being transferred to the consumer as a direct result of new technologies: more aware and better informed, consumers enjoy a far greater freedom of choice.

Sellers can emerge stronger than ever if they are able to understand their customers and earn their loyalty. Supported by the effective management of the data they have about each customer’s behaviour and by the long-term relationships they are able to establish, sellers must find the right product-service combination in terms of both price and quality that best meets individual customer needs, creating solutions with each and every one of them.

What must be stressed in this new balance of power is that any absence of added value in the consumer’s eyes, namely any lack of quality in the advice provided or of offers for improved and customised product-service combinations will lead directly to the complete digitalisation of the customer-supplier relationship. This means the disappearance of the seller’s economic role, with the emergence of a direct producer-consumer relationship or the emergence of pure players based on the internet, a low-cost channel for establishing customer relationships.

The behaviour of producers, sellers and consumers is changing. What about employees?

O.K.: That’s right. Another consequence for companies is the change in employee behaviour. The technological revolution places employees at the heart of the company, which has an impact on the organisation. Nowadays, for example, managers are no longer credible – and are unable to lead their staff – if they do not base their authority on the added value they bring to their teams, as opposed being a repository for information which, in today’s world, circulates freely and unhindered throughout the company.
All the more so as employees are increasingly demanding greater autonomy, sustained and driven by the very same technological revolution. Developing an entrepreneurial spirit has become a major challenge for large companies. Nowadays individuals – and especially company employees – aspire to understand their contribution to the company: they wish to buy in to the strategy and the organisational structure in order to feel that they belong.

Does this mean that traditional organisational structures will have to change?

Clearly, and unless they have been able to modernise, the highly hierarchical and vertical structures born in the 50s and 60s have become less effective and more difficult to manage as the lack of managerial proximity makes it harder to motivate employees. Such structures are more rigid and less flexible and are no longer in sync with a world and business environment that have become ever more complex and fluid. Conversely, companies organised in a network structure, one linking different parts of the company or even between different companies, are more adaptable and more agile, better able to absorb shocks and to manage complexity.
And then there is the social factor. This has to be taken very seriously, as society has become a real stakeholder for the company, thanks to the impact of the internet and social networks. CSR, involvement in wider society and corporate reputation have become key success factors.

In short, to be heard in this new world we have to follow, and even anticipate, how people use technology. This is the very crux of the matter: we are not talking about two different worlds, namely those of the digital and the pre-digital. New technologies have fundamentally changed the way we act and our relations with the outside world.

Greater managerial proximity, a better understanding of customer needs, receptiveness to the entrepreneurial world and an enhanced capacity to absorb shocks, upheaval and complexity; these are the essential ingredients for the modern company. And how do banks feature in all this?

O.K.: Banks are also companies… and, what’s more, the driving force behind the economy. The bank as a company, and more specifically the commercial bank, is not immune to such upheaval, in fact quite the opposite, due to its place at the heart of economic activity.

Whether it’s online banking, mobile banking, payment methods and, more generally, the relationship between the bank and its retail customers, the acceleration of the digital revolution begs the question whether there is still a place for the high street branch. For me, the answer is in the affirmative.

But we must examine the evidence: new digital tools have changed two parameters, namely the time factor and the distance factor. The relationship between the customer and the bank has become direct and the purchase of bank products and services is now performed remotely. The customer is visiting the branch less and less, now typically only to deal with significant projects. And this is the central issue.

The bank has to reinvent itself, and without delay. But the distinction must be made between outdated practices and those that remain indispensable through constituting the very essence of the profession. Two invariables are the pillars on which commercial banking is based. Firstly, demand for banking services is not reducing in volume: it is being expressed differently with new requirements. People do not need banks any less.

Secondly, the personal relationship remains a fundamental element of the role of the high street bank. Banking is not a business that produces products as such, it is all about human relationships based on the ability to offer good advice and good service at the right time, irrespective of which channel is being used. Banks deal with long-term personal and corporate projects, which presupposes a personalised and sustained relationship with the relevant bank advisor. This is precisely what our customers are telling us.

So what is to be done? Should online banking services be set up, without human contact and to the detriment of the branches?

O.K.: Our goal must be to reinvent the high street bank. I stress that the personal relationship between the advisor and the customer is non-negotiable, especially for a banking group composed of regional high street banks.

Our strength lies in our ability to promote what I call “non-remote” banking, as opposed to remote banking which assumes that a complete range of banking services can be provided without a branch network.

What is the basis of this concept? Quite naturally, what customers are demanding with the technological revolution but without curtailing a strong personalised relationship: greater convenience. Maintaining strong relationships with their banking advisor but via the channel of their choice, whether by phone, e-mail or physical appointment, depending on the matter at hand and the time of day… But this also demands a better response to the need for advice that is better thought through, more relevant and more appropriate. It’s the end for products that banks have wanted to sell via a succession of poorly differentiated campaigns.

Provided that it is more agile, more interconnected and more proactive, the branch network has everything it needs to maintain its fundamental relationship with the customer by combining its strength – proximity – with new tools, such as the internet, tablet and smartphone. This means combining the best the traditional bank has to offer with the best of the online bank.

In practice, in each branch each advisor must therefore become a multi-channel agent. As I have already said, this means offering customers the possibility of approaching their regular advisor in order to deal with their important issues in the manner of their choosing, whether face-to-face, by phone or by e-mail, without having to change location. And above all, this must be always with the same advisor. As for the rest, namely day-to-day banking, this can obviously be conducted by mobile phone. Of course we can also develop online banking alongside the branches, with named advisors for highly mobile customers or those with little availability.

What are the risks of developing such a corporate strategy?

O.K.: The greatest risk of all would be not to admit that change is vital. But it must be done in harmony with certain basic and unchanging principles. We must also mention the amount of investment required. Such a model of “non-remote banking” automatically means higher wage costs than those associated with low-cost remote banking. This will require the bank to focus its resources – beginning with its employees – on providing added value in order to justify the costs of the services offered. And, consequently, to exploit our human capital, the bank’s only real differentiation factor. Competence, reactivity and proactivity are all key. As is the intelligent and non-intrusive use of pertinent CRM (“big data”) in order to best anticipate individual customer needs. But also, and above all, we need to profile the networks to make them more agile, distribute expertise better and optimise physical and digital structures. The branch is not dead, far from it. But in the future it must combine two concepts: the e-branch and the physical branch, i.e. the best of modernity and the best of tradition. It has to be more mobile, more alert.

The point is to ensure that we come out on top. This can also be achieved through new technologies. They do not simply a threat. In an environment where banking revenue is showing a clear downward trend in macro-economic terms, the major challenge of such a model is strategic. Should we fail to meet customers’ expectations, they will naturally move to the cheaper pure-player banks online, without a qualm.

So the issue is internal transformation, namely to increase each advisor’s added value and our ability to make our network more responsive. New technologies will be able to help us in return.
But we cannot bury our heads in the sand: this new direction implies a number of long-term development projects. In broad terms, we need to redesign systems to support sales staff and review processes using digital to redefine the customer experience, extending from front to back office. This means, for example, that the lives of our customers and of our employees must be made easier while keeping a lid on costs, that customers must be included in and must be able to benefit from the development of new product contracts, that we must be able to offer e-signature, etc. A genuine process of organisational reform is underway.

Which element would you like to stress in order to gain the commitment of your employees to the project?

O.K.: Our employees understand that, more than any other bank, we must be receptive to the new modes of behaviour and new technologies used by our customers and in wider society, all the more so as, once again, it is our focus on the relationship and the quality of the service provided that set our bank apart from the competition. So this is vital.

But the reforms will also enable each advisor to develop a role as the manager of their own portfolio. In practice, this technological revolution will offer a level of freedom that will empower our sales personnel. A career in banking is becoming more and more exciting. And the position of branch manager will regain a real sense of purpose. Could there be any greater motivation? We must bear in mind that the bigger the institution, the more it needs proximity – in terms of both customer relationships and the management of its employees.

November 2015

Categories
Bank

“Yes, there is still a place for the high street bank”

New technologies are transforming whole swathes of the retail economy and traditional consumption models. And retail banking is not immune. Whether it’s online banking, mobile banking, payment systems and more generally the relationship of the retail bank with its clients, the acceleration of the digital revolution begs the question of whether there is a still place in the world of tomorrow for the high street bank.

New digital systems have transformed the time factor, the relationship between customer and bank has become immediate and transactions frequently take place remotely. At the same time, they are encouraging a process of “hypercustomisation” of the service: “The bank is no longer somewhere you go. It is something you do”, concludes Brett King, author of “Bank 3.0”.

The compression caused by innovation and the new consumption models it creates translates into breakthroughs we could hardly have imagined even a short time ago. Customers are visiting their branches less and less, increasingly only to discuss significant personal projects.

The bank has to reinvent itself. But first we must separate outmoded practices from those that remain essential as they are the profession’s very essence. The commercial bank is supported by two invariables. Firstly, demand for bank services is not diminishing, it is being expressed differently through new customer requirements. Secondly, the face-to-face relationship remains a fundamental aspect of the profession. The digital revolution is not severing the tie between the customer and the bank advisor. It is diversifying the channels through which the relationship is structured. The banking relationship is not based on products, which multiply in an instant without copyright. Banking is a profession of human relationships founded on the ability to offer sound advice and good service, at the right moment and irrespective of the channel used.

First we must separate outmoded practices from those that remain essential.

We must promote face-to-face banking alongside remote banking.

So what is to be done? Wait passively until the bad times are over? That would be suicide. Reduce our capacity in response to possible or already existing declines in banking revenues? I believe that such a move alone is unlikely to bring a positive outcome. The only way forward is our ability to reinvent local banking, and therefore to promote face-to-face banking rather than rush headlong into remote banking. What do our clients require from the technological revolution? More convenience and more appropriate advice, not products we are determined to sell them at all costs via a succession of undifferentiated advertising campaigns.

Provided that it is more agile, interconnected and proactive, the high street bank has everything it takes to preserve its fundamental relationship with its customers by combining its strengths (proximity) with new tools (smartphones, tablets, the internet, etc.).

In other words, the ability for customers to choose which important matters they wish to discuss with their advisor in person, by phone or via e-mail, without having to go out. The rest, the day-to-day banking matters, can clearly take place via remote devices.

Such a model of face-to-face banking necessarily implies higher personnel costs than those for remote, low-cost banking and is only workable if the customer is prepared to pay for the level of service provided. This must lead our banks to concentrate their resources, beginning with their employees, on an added value basis. And putting a maximum into human capital, the bank’s only real differentiating factor.

These are the major challenges for high street banks. Rise above the problem, not fall back on the lowest common denominator. Find the highest added value for the customer. It can be done.

Categories
Bank Global economy

What are banks for? “A return to fundamentals”

Guilty! Weren’t the banks accused of being responsible for the financial crisis triggered in 2007? A necessary vent for the economic difficulties, they continue to face legitimate criticism. And yet, without banks, there is no economy.

I believe that it is now time for a number of important ideas to take centre stage.

Commercial banks play a fundamental role: they take in savings and make loans, acting as intermediaries between those with financing capacity and those requiring financing. In developing countries, a significant proportion of national savings never enters any rational and efficient allocation system. The majority of the population do not have a bank account and invest in assets or hoard their cash. This system is inefficient as savings are not invested to produce growth, namely in support of individual and corporate projects. The financial markets are de facto exclusively the reserve of a few, large companies, due to the costly and regular requirement to produce information to attract investors for bond issues.

Thanks to their in-depth understanding of clients, households, professionals, SMEs and even large companies, the banks are better able to assess the borrower’s profile, and therefore to make appropriate allowances for the credit risk. By their very nature, they are able to minimise the information imbalance that exists between the lender and borrower. They therefore enable numerous economic stakeholders to finance their projects.

Furthermore, by investing in banking products, savers take a risk with the bank and not with the multitude of borrowers to whom the bank lends. Through its role as intermediary, the bank also plays a crucial economic and social role.

The second function of the commercial bank is to take on the so-called transformation risk associated with interest rates and liquidity. Such risks emanate from the fact that both households and companies most often favour short-term and readily available investments, while borrowers most often require long-term financing of a sufficient duration so as to make the investment profitable or to generate a savings capacity to repay a property loan.

The commercial bank therefore acts in the interests of the economy by centralising risk which it assumes in place of other economic stakeholders, thereby promoting growth. For their part, the financial markets bring sufficiently large and well-informed borrowers and lenders into direct contact, leaving them to manage all such risks.

There is a clear understanding of the importance of defining the most appropriate regulations to enable the banks to fulfil their role while guaranteeing maximum security for their depositor clients and, more broadly, the financial system as a whole.

The most recent crisis confirmed the intrinsic instability of finance. And the inescapable necessity of effective bank regulation. But it has to be given in the right doses. Any overreaction which excessively restricts the risks taken by the banks would give rise to another – and equally worrying – danger, namely that of strangling the economy by curbing the availability of finance. Only in very limited circumstances can the markets take the place of the banks. Excessive restrictions may also push the banks into transferring risk to companies and the general public by directly or indirectly selling them their securitised loans or, for example, by primarily only granting variable-rate property loans. This could also encourage a form of parallel, “shadow” banking system which is virtually unregulated.

By over-reducing bank risk due to the otherwise perfectly legitimate desire of obtaining “Phoenix banks” rising out of their own ashes (bail-in) and not needing to be saved by the state (bail-out), could lead to the trading risk taken by the commercial banks being transferred to other players in the economy, ultimately the taxpayers.

So correct regulation can only be arrived at through precise analysis of the situation in question. The indispensable and irreducible role of the banks in the economy must therefore be correctly understood to avoid an outcome contrary to the desired objective.

Download this article

Categories
Bank Global economy

What are banks for ?

Banks have been widely held responsible for the financial crisis which began in 2007. The reality is more complex, although banks – especially those in the US and UK – were certainly implicated in the crisis and may have aggravated it. However, our purpose here is not to hark back to the origins of the crisis but rather to answer questions regarding the purpose of banks and their usefulness in support of the economy.

The fundamental role of a commercial bank is to collect savings and make loans. This may be self-evident, but it is at the heart of the matter. And this can be demonstrated in developing economies, including emerging economies, where banking among the wider population is rare. In such countries a proportion of national savings, the largest proportion, does not flow within a rational and efficient allocation circuit. Most of the population invest in assets, sometimes leading to bubbles, or hoard their assets in cash. This is an inefficient system at the end of the day, as savings are not invested in support of growth, namely in individual and company projects.

The reality is somewhat different in France, of course, as the multiplication of branches since the 1960s has led to nearly 100% of the population holding a bank account. In developed countries, banks therefore play an essential role in the collection and proper allocation of savings. In particular, the ability to obtain loans from economic players in the financial markets has been severely reduced, with the exception of large companies and certain medium-sized ones. Issuing debt on these markets means you have to be known, you must make regular issues, frequently use rating agencies and therefore spend significant amounts of money to ensure the abundance of information about yourself. You have to be of a certain size to be able to absorb the costs involved, to entice investors to analyse your accounts and, accordingly, reduce what is known in economics as information asymmetry between the lender and borrower.

Yet all players in the economy have financing requirements. And this is precisely the role filled by banks thanks to their in-depth knowledge of borrowers, whether households, professionals, SMEs, medium-sized companies and even large concerns. Over time such in-depth knowledge enables banks to understand the profile of the borrower, the context of the loan and therefore to adequately take into account the credit risk. They are also helped in this by their management of their clients’ payment flows.

The usefulness of banks is also clear for savers (investors). Most lack sufficient financial standing to take on a concentrated credit risk with just a few debt issuers. So it is the bank’s role to borrow from savers and to take the credit risk with clients requiring financing which, in the event of a proven risk, has an impact on its own balance sheet. In other words, by investing in banking products, savers take a risk with the bank and not with the multitude of borrowers to whom the bank lends. Through its intermediation, the bank therefore plays a crucial economic and social role, both by matching up financing needs and capacities and itself taking on credit risk instead of the savers.

The second role of a bank is to take on interest-rate and liquidity risks which arise from its activities of collecting savings and granting loans. This is its activity of “transformation” (of deposit and loan maturities). In practice, households and companies alike most often favour short-term investments that are readily available. But most borrowers wish to borrow over the long-term that is over a sufficiently long duration so as to make a return on an investment in a company or gradually generate a savings capacity to pay off a property loan, for example.

The markets can certainly play a role in this respect. But purchasing a seven-year bond issued by a company, for instance, not only carries a credit risk for the investor over many years, it also entails an interest-rate risk that gives rise to a risk of capital loss in the event of resale prior to the term. Purchasing bonds or any other type of debt entails a capital gain/loss risk, according to fluctuations in interest rates.

These may vary wildly as has happened many times over the past thirty years. On the other hand, if a saver makes an investment through a bank, then he bears no risk of capital gain or loss, as the interest-rate risk has been transferred to the bank which has the required professional expertise to manage it, and which complies with prudential regulations in such matters. The bank records any losses associated with the occurrence of such a risk in its own books, yet without undermining the value of the investments of its saver-customers, unless the bank itself goes under.

In addition to interest-rate risk, lending over the medium term and borrowing over the short term entails a liquidity risk. Savers who have made short-term investments or deposits may wish to withdraw their money while it is frozen by the bank in medium-term loans. In the markets, the liquidity risk is offset in principle by the secondary market. A share or bond can in principle be sold on this market at a capital gain or loss (see above). But in reality liquidity is “self-referential”.

A market is not liquid intrinsically but because investors believe in it. Should this belief disappear and investors have fears about liquidity, they will stop buying and no sales will take place or only at prices way in excess of the “normal” value of the securities in question. This liquidity risk is borne by everyone who directly participates in the financial markets. In the case of the banks, liquidity risk is managed by the bank on a professional basis and, once again, in compliance with ad hoc prudential ratios. As a last resort, central banks may intervene and provide liquidity for the banks. This happened on an international scale in 2008, and then again in 2011 during the euro zone’s specific liquidity crisis.

In summary, banks are not only indispensable for the rational allocation of savings but also, and unlike the markets, they also assume credit risk, interest-rate risk and liquidity risk in the place of their customers. And such risks are taken under regulation and supervision. Banks’ specific and irreducible economic and social usefulness is based on these functions as a whole.

In this paper we will not cover investment banks, which play an advisory role and whose purpose is to participate in the financial markets as an intermediary, placing buyers and sellers in direct contact and originating securities on behalf of borrowers.

One question needs to be addressed today: do the new banking regulations improve banks’ ability to manage risk? Macro-prudential regulations are vital, as the markets can regularly become disconnected from economic fundamentals. The more markets are globalised, the more volatile they become and the greater the risk of bubbles emerging. Self-evident market errors therefore occur regularly.

For example banks, like the markets, may be encouraged in more euphoric times to lend too much, causing borrowers to incur too much debt, thereby contributing to the development of credit bubbles on assets (shares, property, etc.). This then leads to turnarounds and overly sudden credit rationing and sharp falls in asset prices. Furthermore, and this is the historic basis of regulation, micro-financial regulation is required to protect savers’ deposits in every bank and hence ensure the stability of the banking and financial system, which is indispensable to a smooth-running economy. But when clear and repeated market errors occur, regulatory errors can also be made.

Given the requirement to comply with minimum solvency ratios, regulation obliges banks to hold sufficient capital in light of the risks they assume (market and credit risks). Regulation also makes it possible to reduce liquidity risk since Basel III.

Yet some regulations at times have undesired effects. For example, certain conditions were pro-cyclical under Basel II. They actually exaggerated both euphoric and depressive effects. By enabling banks to reduce their capital or increase their commitments in the event of an upturn in the economy and financial markets, they encouraged greater risk-taking, leading to speculative bubbles (credit, market and other). Conversely, in the event of a downturn, banks had to increase their capital or reduce their commitments without delay, while making provisions on loans and adopting negative positions in the financial markets, thereby accentuating the depressed economy. Basel III has at least partially corrected these pro-cyclical effects by requiring contra-cyclical capital buffers. Sometimes a regulator over-corrects past crises and fails to anticipate future crises.

One problem is always encountered with each new phase of prudential regulation: how to strike a balance between too little regulation, which would pose a risk to financial stability, and too much regulation, which poses a no less tangible risk to growth and, potentially, to financial stability itself. Cutting too sharply the interest-rate, credit and liquidity risks taken on by banks within the context of their commercial activities would in turn hamper economic activity or transfer such risks to other participants in the economy, namely businesses, the general public or professionals.

For example, to avoid taking interest-rate risks, UK and Spanish banks developed variable-rate mortgages. As rates rise, borrowers find themselves under pressure, even trapped. Unlike the banks, non-bank players in the economy are only rarely able to manage such risks, which are inherent to economic activity and to a discrepancy between the wishes of economic players with financing capacity and those who require financing. Accordingly, each time banks are asked to take too few risks resulting from their economic activity as lender and collector of savings[1], this risk is transferred to players who are neither regulated, supervised nor professional.

Too much regulation excessively reducing the ability of commercial banks to take on the risk inherent to their economic role would in practice lead to a reduction in their business activities, transferring risks to non-regulated players – either directly to economic participants who are ill-suited to manage such risks or to the “shadow banking” sector, leading to a build-up of uncontrolled risk. This is what has once again been happening over the past three years on a very large scale, as the IMF, very recently pointed out by sounding the alarm over the potential danger of systemic risk.

Furthermore, if in order to reduce the volume of risks taken by banks we encourage them to further securitise their loans, they once again transfer their interest-rate, credit and liquidity risks to investors which are little or not at all regulated. To which it should be added that securitisation increases the volatility of banks’ earnings.

Normally, a variation in commercial banks’ earnings is a slow process as they live off the margins between the interest rate on their stocks of loans and that on their borrowings and deposits, and off the commissions on the services and products they market. But if banks were tomorrow required to securitise their loans much more, instead of being calculated on their stocks of loans, their earnings would be dependent on the volume of loans produced in a year, on throughput, making their earnings unsteady – hardly conducive to overall financial stability.

Though a source of instability in many ways (inconsistent earnings by banks and transfer of risks from regulated banks to other, unregulated players), securitisation can nevertheless be positive, provided it takes place on a marginal basis and under the right conditions. The sub-prime example is proof enough that banks are capable of the very worst in this area.

To avoid such excesses, banks must remain responsible for the loans they provide (retaining a minimal percentage of risk on securitisation as provided for in Basel III, in order to avoid the “moral hazard” effect), and they must retain most of their loans on the balance sheet. Securitisation can only be a supplementary – and regulated – solution if financial stability is to be maintained.

Following the financial crisis a new objective emerged, one that is understandable, but dangerous if becomes obsessional, namely that of never again bailing out the banks from the public purse, that is, the taxpayers. Hence all the new regulations and those being worked on to avoid government bail-outs or to force bail-ins via the banks’ shareholders and creditors, following the idea of a “Phoenix” bank rising from the flames. The objective is laudable, but it must be well targeted. Remember that in France banks have paid back all the money lent by the state during the crisis. But above all, the wish not to have to bail out the banks via the taxpayer, though it must legitimately lead to more effective prudential rules, must not excessively trim the risks naturally taken by banks in the course of their commercial activities.

Banks are simply the risk depositaries, notably interest-rate, credit and liquidity risk, as stated above. Let us repeat it once again, the banks themselves take on the risks. And this enables other economic players to take significantly fewer risks or avoid them altogether. They do this in a professional and regulated manner, under supervision which must be unfailing. If the risks taken by banks are overly reduced, this will not lead to taxpayers spending less. If the banks themselves no longer adequately concentrated all the risks, the economy would be strangled or, without actually reducing risk and even increasing it for the reasons stated above, it would be transferred upstream to other economic players, namely the taxpayers. This would increase precariousness in times of tension or crisis; risk would be scattered and its traceability lost. With time, general financial instability would be increased.

Of course, here we are interested in the risks inherent to banks’ commercial activities and not to their proprietary market activities. So these different situations must be clearly separated out in order to establish fair regulation. The indispensable and irreducible role of banks in the economy must be properly understood to avoid harming the economy and possibly causing an outcome that is the opposite of the one being sought. And finally, as is so often the case, effective and durable solutions require judgement and moderation.

Donwload “What are banks for ?” (PDF)

[1] Thoughts in Basel are currently turning to implementing stricter regulations for the interest-rate risks taken on by commercial banks by modifying agreements for flows of sight deposits, considering – contrary at least to the French experience – that deposits are less stable; this therefore further constrains the ability of banks to convert short-term savings into long-term loans. This would then prompt banks either to increase securitisation or transfer their interest-rate and liquidity risk to non-banking economic players.