The banks’ business model – between function and transformation

What is a business model?

Magretta delineated the business model from the point of view of an entrepreneur: “Who is the customer? And what does the customer value? It also answers the fundamental questions every manager must ask: how do we make money in this business? What is the underlying economic logic that explains how we can deliver value to customers at an appropriate cost?” According to Skarzynski and Gibson, “We define a business model as a conceptual framework for identifying how a company creates, delivers and extracts value. It typically includes a whole set of integrated components, all of which can be looked on as opportunities for innovation and competitive advantage.”

Business models have many dimensions and levels. The traditional view has not lost its significance, even if business models today are presented as a type of unit of analysis going beyond the traditional approach. This requires that the company asks itself about not only the benefits that it brings to the customer, but also about which sources it can generate profits from along the value chain. A company must deal with the dimensions of effectiveness and efficiency in its work, which ultimately determine its comparative competitive advantage. This can be defended both commercially and with regard to the competitive position achieved. Determining a business model continues to bring together customer and corporate perspectives through the overarching objective of generating and securing a competitive advantage. An essential dimension in determining a business model is innovation, and the customer remains the primary reference point for this. Therefore, the questions that traditionally have to be asked are: what is a bank to a customer? Or: which services do customers expect from a bank? What are the company’s profit sources and influencing factors?

What customers expect from a bank, by which means and via which methods customers’ wishes are fulfilled, as well as how these services can be rendered while generating sustainable corporate success, have fundamentally changed in recent years. Today’s technical possibilities also provide customers with the transparency to compare and use not only the market for the bank services they are looking for, but also the market for other providers. Today, business models must reflect the evolutionary and disruptive changes in economic and social communal life. Customers are not interested in the generalised services offered by the bank, but rather in the tailored solutions offered to help them attain their specific life goals, which are determined ever more strongly by digitalisation (as a transformative process in economic areas).

Banks are facing new competitors that are not even banks, but are, for example, FinTechs and RegTechs. The financial services market is being penetrated ever more rapidly by companies from the technology sector, since these companies are not burdened by prior developments in the financial services market. These companies offer products that are, for the most part, subject to fewer regulatory requirements than traditional banking business, in particular in the area of payment services.

Banks’ typical and most important profit source, interest income, has fallen away to an enormous extent. The intensifying competitive situation for banks has already been accompanied by a persistently low interest rate phase for a very long time. Naturally, the low interest rate environment most intensely affects the collective savings and risk models, such as those of a building society. Overall, a weakening of a large number of banks can be observed as a consequence. The growth in the income sources of fees and provisions has not compensated for the decline in interest income so far.

The changed role of banks is reflected in the development of the DAX, in the domestic product and in the number of staff employed at banks. However, financing the economy remains an important macroeconomic responsibility of the banks.

The number and complexity of the legal and supervisory requirements of companies that offer bank services to customers has expanded enormously. The objective of reliably ensuring the banks’ role as important financial intermediaries is, however, also associated with rules that place definite limits on business models. Implementing the legal and supervisory requirements is therefore associated with a considerable financial impact, which is even more daunting in the face of weakened profit sources from the regulated activity.

Responding incorrectly to these business administration issues is not the only way in which a company can end up in a situation that threatens its very existence. More than just painful consequences can arise rapidly for companies that use the business model of a bank and yet do not recognise the sensitive and multidimensional interaction between legal and supervisory regulations tied to the business model and business strategy. For example, the minimum requirements of risk management require that the directors set out a sustainable business strategy that illustrates the objectives for the business activity and the measures that must be taken to achieve these. The business strategy must encompass the objectives for managing the core business activities and the measures to achieve these objectives, in particular with regard to the earnings situation; this requires familiarity with the profit sources. The accounting standard IFRS 9 “Financial Instruments” – the central standard for illustrating the business activity of financial instruments in the annual financial statement, including evidence of success – is linked to the business model. Meanwhile, this is the basis for regulatory reports published by banks. The connection between a business strategy that is to be determined according to the minimum requirements of risk management and the underlying business model for classifying the financial instruments, which is in accordance with IFRS 9, is therefore given a key role, even if the business strategy and the business model have other aggregation levels or evaluation levels. The requirements for determining the business model from the perspective of risk management and accounting are the basis not only for the evaluation of a bank by the market and by the supervisory authorities, but also for determining the very expensive maintenance of minimum capital.

New information technologies are seen as a solution in the fight against the loss of customers and in the fight for profitability in the traditional banking business.

Generating regulatory efficiency is one of the most important management topics in determining the key to success for banks. For example, RegTechs are the result of the search for efficient technological solutions for implementing the increasingly complex legal and supervisory requirements of banks. The use of innovative technologies, such as big data and data visualisation technologies, cloud-based services, block chain technologies, components of artificial intelligence and technologies that relate to the specialist and functional/process perspectives, are expected to provide efficient solutions.

A strong position in the banking market arises from a deep understanding of the customer. Large quantities of inhomogeneous data are processed at high speed from very different sources and with a wide variety of structures. Big data is an important production factor. The quantities of data and data points that can be evaluated are continuously increasing with the growing digitalisation of business models. To this end, company-internal data are generated using scientific research results from neuroscience, risk research, psychology and criminology. These data quantities are becoming an important asset.

This puts the issue of data security as competitive safeguard on the agenda. Cyber risks are developing as a new risk field. The increasing importance of data processing and technological information and communication networks requires that transactions are secured (cybersecurity). Modern technologies lead, on the one hand, to cost savings, but on the other hand, they result in an increase in costs for securing the data. The cost of big data may also arise from legal uncertainties associated with its use. The collection, analysis and generation of structured and unstructured information about customers and their behaviour are confronted with European data protection principles and regulatory frameworks (e.g. the General Data Protection Regulation – GDPR).

In conclusion:

it is not without reason that the analysis of the sustainability of the business model as an elementary competitive factor for surviving rapid change processes is an essential component of the Supervision Review and Valuation Process (SREP) of bank supervision. The analysis of the business model focuses in particular on the success and risk drivers that the directors of the bank must be familiar with and that must be documented in a suitable manner for communicating to the supervisory authorities. The selection of a business model determines both the realisation of profits and the cost-risk structure. Cost minimisation and the analysis of profitability are consequently core elements of the supervisory authority’s business model analysis.

Modern technologies, such as block chain, the Internet of Things, machine learning, biometrics, cloud computing, internet technologies, ascertaining and using a virtual organisation as well as the reintermediation and the disintermediation of internet-based markets have found their way into the banks’ market. A financial market based on modern technologies will change continuously and ever more rapidly, requiring more than just an adjustment of business models; the development is associated with new risks, which must be anticipated in good time not only by companies, but also by the supervisory authorities.

Example: information technology as a key factor in business models

An example of a bank that recognises new information technologies not only as a factor for success, but has also made them a central element of its business model, is the Russian Sberbank. Its declared objective is to be a fully integrated financial institute with a comprehensive product range. This bank has made technological innovation the basis of its business model in order to become a market leader in the newest digital mobility and social technology, cybersecurity, analytics and working with big data. In the last few years, Sberbank has concluded its transformation from a type of savings bank into a general financial services provider. A high-performance infrastructure and highly effective IT systems are implemented to design and monitor both business processes and systems along the value chain in a standardised manner and to minimise the time taken for new product developments to launch on the market. The consistent automation of working areas in a large number of sectors led to changes in management hierarchies and to increasing centralisation. Computerisation also took place in specialist areas in which the replacement of highly qualified academics with machines was unthinkable just a few years ago, such as in the legal department, where, for example, even statements of claims are partly dealt with using artificial intelligence. The CEO of Sberbank estimated in 2016 that in five years’ time, artificial intelligence systems would be able to take over 80% of the decisions made in the bank by humans. The bank has already replaced thousands of employees with “robots”. By focusing on the development of technologies and innovations, the provision of new bank services for customers, such as consulting, IT training, the provision of cyber insurance policies (combined with consultation in the area of insurance cover) and cloud computing, was expanded. Virtual laboratories and cyber practice areas, as well as collaborations with universities and globally leading IT companies, form the foundation for further innovation processes.

Compared with standardisation as a solution for increasing efficiency and reducing costs, implementing tailor-made concepts for customers appears at first glance to be inconsistent with business objectives. Innovative information technologies are, in many respects, the key to minimising costs for Sberbank, on the one hand in relation to the organisation of business processes and on the other hand in relation to risk costs. The use of big data led to a reduction in non-performing loans. By using big data, it was possible to offer loans tailored to the needs of the customer which also have comparatively low and risk-adjusted interest rates.

^{(1) Magretta J. (May 2002): Why business models matter
Joan Magretta is senior associate at the Institute for Strategy and Competitiveness at Harvard Business School}

^{(2) Skarzynski P., Gibson R. (March 2008): Innovation to the core: a bluepoint for transforming the way your company innovates
Peter Skarzynski is CEO and founding Director of Strategos, a consulting firm he cofounded with Gary Hamel
Rowan Gibson is a global business strategist and editor of the international bestseller Rethinking the Future: Rethinking Business, Principles, Competition, Control & Complexity, Leadership, Markets and the World}