COVID-19 likely to accelerate banking sector’s pre-crisis trends

The COVID-19 health crisis will stretch the limits of central bank intervention and test the tenuous Banking Union in the euro area. These are two key findings of the second report in the “The Future of Banking” series by IESE Business School and the CEPR, which examines the mounting, and unprecedented, challenges facing the sector and the competitive responses of both veteran and new players.

The report notes that while banks have performed robustly in the immediate wake of the pandemic, mostly thanks to overhauls and increased liquidity stemming from the 2008 financial crisis, they face a potential fallout from impending large-scale household and corporate bankruptcies.

Banks also face significant pre-existing threats such as persistently low interest rates; regulatory changes; and growing competition from the shadow banks and digital upstarts that were challenging traditional business models well before the pandemic and its attendant economic devastation.

An Altered Digital Future

A central finding of the report is that the health crisis will accelerate these pre-crisis tendencies of the banking sector, as digitalization advances at a more rapid rate, interest rates remain low and growth stalls. The report also analyses the policy and regulatory issues associated with the digital world, and suggests future policy options for reform.

Its key findings include:

• In the short term, banks may enjoy a revitalisation of relationship lending as they channel funds to customers over the crisis and, enjoy the protection of the safety net and access to deposit financing.
• While banks may enjoy temporary regulatory and supervisory relief, digitalisation will receive a large impetus, with new entrants challenging banks.
• Digitalisation will increase the reduction in barriers to entry and exit of the financial services market, but its long-term impact will depend on the market structure that prevails. The result may be that a few dominant platforms, which include both transformed incumbents and BigTech firms, control the access to a fragmented customer base.
• Medium-sized banks will suffer since they cannot manage the cost efficiencies and IT investment crucial in the new environment. Consolidation could be an escape route to stressed banks but in the post-Covid-19 world, political obstacles to cross-border mergers may resurface as states become more protective of their national banking system.
• Regulators must adapt to digital disruption by balancing their roles of facilitating competition and of allowing the benefits of innovation, whilst protecting financial stability. This means they must coordinate prudential regulation and competition policy with data policies, navigating complex trade-offs.

Finally, the current crisis will undoubtedly test the resilience of the financial system and of the regulatory reforms implemented after the global financial crisis of 2007-2009, which were examined in the first report of the Future of Banking Initiative by IESE and Citi.

The report was prepared by Xavier Vives (Professor of Economics and Finance, IESE), Elena Carletti (Professor of Finance, Bocconi University), Stijn Claessens (Head of Financial Stability Policy, Bank for International Settlements) and Antonio Fatás (Professor of Economics, INSEAD Business School).