SUNANDO ROY – On Banking, Finance and Society

Business model analysis (BMA) is a key component of supervisory frameworks in many jurisdictions that allows supervisors to identify banks’ vulnerabilities at an early stage and helps to ensure safety and soundness. Therefore, supervisory process should be more proactive to systematically assess the sustainability of banks’ business models. Supervisory approach towards analysis of bank  business model typically adopts a risk focused approach with a set of  assessment elements. These elements mainly  involve capital adequacy, management quality, risk management, transparency and disclosure, asset quality, liquidity and earnings. Weaknesses identified in such procedures lead to recommendations to Banks  to ensure effective management and control initiatives to maintain the financial stability by reducing the risk of insolvency, and instances of losses to depositors or investors; thus, ensuring consumer protection and  preserving market trust. Maintaining  sustainable Bank business models is thus a core component of achieving financial stability objective of central Banks.  In April 2022, the Bank for International Settlement (BIS)  issued  a detailed guidance on assessing sustainability of  bank business models. The guidance specifies  criteria for the assessment of the business model and strategy of banks. While the guidance is bank-centric, it is possible to extrapolate the suggestions to other financial institutions.

The present blog suggests that the Board of Directors of Banks should not wait for such supervisory assessments and react to suopervisory recommendations. Instead, the Board should proactively ask for periodic business model assessment as a powerful tool to calibrate the business model through necessary risk adjustment. The outcome of the BMA is expected to  support the overall risk-based  Board oversight  process to discover of the institution’s key vulnerabilities and rectify them in a timely manner.

Business Model Analysis process : Seven Steps

The business model analysis is performed through a  well-calibrated , integrated seven step approach. The seven steps are intertwined in such a manner that leaving out a step or changing the sequence of steps can affect the critical dependencies in assessment framework and impair its efficacy.

 

Step I:  Identifying the areas of focus

The BMA starts with identification of  the focus areas. It should focus on the business lines that are most important in terms of viability of current business model, or are most likely to increase the institution’s exposure to existing or new vulnerabilities in adverse market conditions. The identification process ( Step 1) should take into account:

• the materiality of business lines – whether certain business lines are more important in terms of generating profits (or losses);
• previous supervisory findings – whether the findings for other elements of the SREP can provide indicators on business lines requiring further investigation;
• findings and observations from internal or external audit reports – whether the audit function has identified specific issues regarding the sustainability or viability of certain business lines;
• importance of identified business lines/activities to Bank’s overall  strategic plans – whether there are business lines that the institution wishes to grow substantially, or decrease;
• Relevance of identified scope to changes in the business model – whether there are observed de facto changes in the business model that have occurred without the institution declaring any planned changes or releasing new strategic plans.

 

Step II : Assessment of Business environment

To form a view on the plausibility of an institution’s strategic assumptions, Inspection team should undertake an analysis of the business environment. This takes into consideration the current and future business conditions in which an institution operates or is likely to operate based on its main or material geographic and business exposures. An understanding of the direction of macro-economic and market trends and the strategic intentions of the peer group will be necessary for this assessment. This can be done with the help of IMF, BIS, World Bank datasets and reports  and published government reports and databases . Beyond the need for access to relevant data, this  analysis requires an understanding of the key macro-economic variables within which the relevant entity, product or segment being assessed operates or will operate based on its main geographies. Examples of key variables include gross domestic product (GDP), unemployment rates, interest rates and house price indices.  It also needs to understand the competitive landscape and how it is likely to evolve, considering the activities of the peer group. Market trends  that may have an impact on the institution’s performance and profitability. This should include, as a minimum, regulatory trends, technological trends and societal/demographic trends.

Step III : Analysis of the current business model

Empowered with an assessment of the business environment ( Step II) , the supervisors should   understand the means and methods used by an institution to operate and generate profits with the help of quantitative and qualitative analyses.

Quantitative analysis  should include: (a)Profitability level and trend: assess the underlying profitability of the institution (e.g. after exception items and one-offs), the breakdown of income streams, the breakdown of costs, impairment provisions and key ratios (e.g. net interest margin, cost/income, loan impairment). Inspection team should consider how the above items have evolved in recent years ; (b)Capital and Asset Quality trends: assessment of  the asset and liability mix, the funding structure, key ratios (e.g. return on equity, Core Tier 1, funding gap); (c) Concentrations: evaluation of  concentrations in the P&L and balance sheet related to customers, sectors and geographies and (d) risk appetite: analysis of  the formal limits put in place by the institution by risk type (credit risk, funding risk, etc.) and its adherence to them to understand the risks that the institution is willing to take to drive its financial performance.

The quantitative approach should be supported by an analysis of qualitative features of the institution’s current business model to understand its success drivers and key dependencies.  Areas for analysis should include:  a. key external dependencies: Inspection team should determine the main exogenous factors that influence the success of the business model; these may include third-party providers, intermediaries and specific regulatory drivers; b. key internal dependencies: Inspection team should determine the main endogenous factors that influence the success of the business model; these may include the quality of IT platforms and operational and resource capacity; c.  Consumer Centric Approach and Reputational Risk: Inspection team should determine the strength of relationships with customers, suppliers and partners; this may include the institution’s reliance upon its reputation, the effectiveness of branches, the loyalty of customers and the effectiveness of partnerships; and d. areas of competitive advantage: Inspection team should determine the areas in which the institution has a competitive advantage over its peers; these may include any of the above, such as the quality of the institution’s IT platforms, or other factors such as the institution’s global network, the scale of its business or its product proposition.

Step IV : Analysis of Financial Projections

 

Next,  quantitative and qualitative forward-looking analysis is necessary to understand banks in a sustainable of the institution’s financial projections to understand the assumptions, plausibility and riskiness of its business strategy. Since predicting the future inevitably involves forecasting models,  plausibility and consistency of the assumptions made by the institution that drive its forecasts should come under scrutiny. Such assumptions typically  include  macro-economic variables, market movements, volume and margin growth in key products as well as segments and geographies. In this context, factors  such as management competence and data scientists determine the institution’s execution capabilities.

Step V : Assessing business model sustainability

 

Once the  plausibility of the institution’s assumptions and projected financial performance in relation to the current and future business environment is reviewed , the sustainability of the model may be analyzed by looking at the risk level of the strategy (i.e. the complexity and ambition of the strategy compared to the current business model) and  the consequent likelihood of success based on the institution’s likely execution capabilities (measured by the institution’s success in executing previous strategies).

 

Step VI   Identification of key vulnerabilities

It is critically important that supervisory assessment include  the strategic vulnerabilities to which the institution’s business model and strategy  is exposed or  may be exposed in the future.  These may encompass a wide range of weaknesses that may undermine the success of a bank’s business model. From past experience, the set of potential vulnerabilities commonly identified in Bank business models include : poor expected financial performance;  reliance on an unrealistic strategy;  excessive concentrations or volatility (e.g. of earnings); . excessive risk-taking; . funding structure concerns; and f. significant external issues (e.g. regulatory threats, such as mandating of ‘ringfencing’ of business units).

 

The above weaknesses are often manifested in  a set of key risk indicators, that should be closely watched as part of business model assessment.  Below is a list , though incomprehensive, that broadly captures the reasons behind the failure of business models. Banks should design their risk appetite around the indicators highlighted below and continue to monitor for signs of weakness. The set of key risk indicators to be reviewed regularly include:

• Unrealistic business projections
• High Risk Appetite in the strategy assumptions
• Frequent Limit breaches and Exception approval
• High level of Concentration is – in assets, funding’s and earning.
• Weak and unstable returns
• Dependence on non-core income and one-off income sources
• Liquidity mismatches and inadequate funding structures
• Weak competitive position, weak or declining customer base, weak market reputation
• Changes in market characteristics resulting in loss of market share
• Inadequate digitalization initiatives
• Poor governance and risk culture including excessive business deals with related parties.
• Lack of synergy and cohesion in the group in case the Bank is part of a group
• Inadequate attention to consumer needs and product strategy is not aligned to business needs.
• Weaknesses in execution and inadequacy of skills and resources.

 

Step VII: Overall Assessment of Business Model

 

Following the above assessment, an overall assessment  of the viability of the institution’s business model and the sustainability of its strategy should be formed, and any necessary measures to address problems and concerns. The overall assessment can be based on, but not limited to, the following  risk-based criteria:

 

Robust   Business Model ( Low Risk)

• There are no material asset concentrations or unsustainable concentrated sources of income. • The institution has a strong competitive position in its chosen markets and a strategy likely to reinforce this.
• The institution has financial forecasts drawn up based on plausible assumptions about the future business environment.
• Strategic plans are appropriate given the current business model and management execution capabilities.

 

Business model poses  a medium level of risk to the viability of the institution.

 

• The institution generates average returns compared to peers and/or historic performance which are broadly acceptable given its risk appetite and funding structure.
• There are some asset concentrations or concentrated sources of income.
• The institution faces competitive pressure on its products/services in one or more key markets.
• The institution has financial forecasts drawn up on the basis of optimistic assumptions about the future business environment.
• Strategic plans are reasonable given the current business model and management execution capabilities, but not without risk.

 

Business Model poses a high level of risk to the viability of the institution.

• The institution generates returns that are often weak or not stable,
• relies on a risk appetite or funding structure to generate appropriate returns that raise supervisory concerns.
• There are significant asset concentrations or concentrated sources of income.
• The institution has a weak competitive position for its products/services in its chosen markets.
• The institution’s market share may decline significantly. There are doubts about its strategy to address the situation.
• The institution has financial forecasts based on overly optimistic assumptions about the future business environment.
• Strategic plans may not be plausible given the current business model and management execution capabilities.

 

Business Model Analysis is a powerful tool for Bank’s Board of Directors. The assessment  allows  Board and supervisors to identify a bank’s vulnerabilities and alert the bank’s management  at an earlier stage, ahead of a regulatory breach and consequent reputation damaging enforcement measures . It also allows supervisors to address these issues before Bank level idiosyncratic weaknesses do not  become systemic concerns which are more difficult to address or resolve and pose threats to financial stability.