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Bank credit risk in the internet age


Moody's Investors Service sees significant new developments affecting the future of the banking industry in the internet age. The main threats and opportunities are the following:

The advent of the internet is a uniquely powerful catalyst for change for financial institutions, but on its own it will not lead to the dissolution of their role as economic agents, nor to their disappearance. Predictions to the contrary appear quite unrealistic for this stage.

However, future changes in the banking industry will be shaped less by the banks themselves (or by banking authorities of various sorts) and more by technological progress and the businesses at its edge (computing, technology infrastructure, communications, portals, etc), which are not focused specifically on the financial sector.

Online banking will continue to expand ineluctably as usage of the internet, e-commerce, and online financial services will broaden. Those banks that position themselves early for the stormy seas of financial entropy will be able to navigate safer than their less prepared competitors.

Wireless internet (one early stage of which is WAP) stands a good chance to become the principal medium for online banking and financial services; versus desktop PC-based fixed internet. At this stage the European market is more advanced than the North American market in mobile communications, primarily in countries like Sweden and Finland.

The internet empowers the customer, who can take full advantage of instant and customised access to all meaningful information, having the capacity to engage easily and conveniently in all sorts of financial transactions. For the customer, a bank's competitor may be only one mouse click away. Even if for various reasons (legal, degree of inconvenience, regulatory, tax, cultural) a majority of customers will not rush to change banks in the immediate future, their own banks will have to operate with the probability that their customers are fully informed about similar products and their price in the market and therefore could at some stage decide to move elsewhere.

The importance of a strong and trusted brand is becoming an essential element underpinning banks' franchise value. This is so because their products are commoditised and distribution is being disintermediated by the internet (the fourth disintermediation, after savings, credits, and operational). Customer loyalty is therefore to a larger extent than in the past anchored (or washed away) by the bank's brand value.

Many banks have established an online presence or aim at it (under their own brand, or using a different one, or both in parallel). Their option is invariably a multi-channel distribution ("clicks-and-mortar"), based on the need to offer online services but also on their conclusion that at this stage branches can still play a role. Banks in developed markets will have to make significant cuts in their bricks-and-mortar networks, as branches will be visited less and generate less profits. In fact, because most banking products can now be offered online or through ATMs, the value of a branch is less of a main distribution avenue and more of a relationship enhancer (customers like to know that a branch does exist in their neighbourhood).

However, bank over-capacity remains a major quandary, and so far mergers and acquisitions are doing little to address it (the US market being to some extent the exception). The dynamics of e-commerce will clash with the rigidities of labour legislation in Europe, as well as with socio-political and cultural realities that remain hostile to massive job restructuring and reductions (in addition banks have to maintain a positive social image). And unlike retailing, banking on the internet does not require massive hiring of staff to physically move the goods purchased online (such as people selecting the merchandise in warehouses, driving the delivery vans, etc.).

Spurred by the internet, which lowers entry and exit barriers significantly, competition in the banking industry intensifies further. The main competition divide is not the one often suggested; between established banks and internet pure plays. Established banks with good and stable brands are expanding and diversifying online themselves, and internet pure plays entering the market, despite the accompanying market noise, have had so far only a marginal impact; be it in the US or UK markets -- their main competitive advantage remaining attractive pricing (high-coupon savings or low-rate credits).

The internet should speed up the convergence of retail financial services; banking, insurance, fund management, a process already well under way in Europe. Online brokerage is about to become an increasingly important component in this convergence.

The emerging power of the retail customer in deciding on tailor-made investments could loosen the lock of the large bank on retail asset management in Europe, with more penetration by smaller and nimbler online brokers and fund managers.

The banking needs of small and medium-sized businesses will be affected by the advent of the internet. Better inventory management leads to lower needs for working-capital bank lines. More efficient cash management reduces the requirement for large transactional deposit balances with the bank. And financing for businesses' investment and growth needs comes increasingly from private equity and from public markets (equity and bonds).

As for the large corporations, themselves structurally challenged in the internet age, it is questionable whether some of the more sophisticated ones will need house banks altogether, other than for ad-hoc needs that do not necessarily generate profits for the bank. B2B trends appear by far to be the most threatening challenge for the banking industry (in wholesale banking).

The internet will speed up the process of financial-industry consolidation in Europe -- in-market, cross-border, and cross-industry alike. The larger banks would aim at strengthening their market position and prevent competitors from filling any gaps, as well as positioning themselves as first-choice candidates for potentially broader alliances and ventures with telecommunication giants, software vendors, or major internet portals. At the same time, the smaller institutions would recognise the uphill challenge high investments in technology and human capital and would therefore be ready to throw in the towel.

The business rationale for mergers and acquisitions will change however. Potential partners will look for brand enhancement, technology and product sophistication, strength of the online franchise, organisational flexibility, and management talent.

Beyond reshaping distribution strategies and moving the business online, the internet and the network economy are challenging the very economic and business fundamentals of banks, and of financial-services providers in general. The traditional hierarchies with which banking organisations operate will have a hard time adjusting to a more entropic market, where products and services can dis-aggregate and then re-aggregate differently. At this stage, however, we see little evidence that many European banks going online are focusing on their business model for the future.

Recruiting and retaining the right breed of managers and professionals will be an uphill challenge for most European financial institutions (and for other businesses in general). The internet age demands a different and more dynamic and entrepreneurial set of skills, as well as a much faster reaction capacity to the higher market entropy. The legal, tax, regulatory, and socio-political environment in many European countries remains however less conducive for creative and self-motivated human capital to flourish.

Moody's Bank Analysis and Ratings in the Internet Age
Moody's analysis and ratings will focus more on banks' online franchise and its sustainability in an increasingly fast-moving and unpredictable marketplace. Brand value will increasingly underpin banks' franchise, as will their capacity to re-aggregate and tailor-make commoditised products individually for their customers; both high-end and retail; and offer them speedily, efficiently, and securely. Elements like faulty online security, inappropriate connectivity and scalability, unfriendly web sites, if not remedied rapidly will undoubtedly hurt a bank's online franchise, and in the cyberspace the bank is only a mouse click away from its competitors.

Intangibles like brand and management vision, talent, capacity to innovate and competence for the new age, are important elements behind bank ratings. Assessing intellectual and knowledge capital and its dynamics is increasingly essential for a bank's future strength and performance. Also important is the caveat that any rush to replace the banking culture with a venture-capital culture may harm customer trust; potentially a mortal blow for a financial institution's franchise value.

Traditional financial ratios; the favourite tool of classic bank analysis; continue of course to tell their very useful story. However, like a hardware shell without software contents, financial ratios on their own may not explain future developments if not corroborated with the relevant intangible elements.

We foresee no short-term changes in bank ratings solely because of the internet impact; unless we identify institutions with growth strategies that appear visibly inappropriate for the cyberspace age. However, in time we would expect to see wider differences among bank ratings and also the potential for steeper rating changes; upwards or downwards; to reflect the faster dynamics of the marketplace. And, because of the weight of the assessment of intangibles in our analysis, some bank rating actions may in the future appear less directly correlated to trends in financial ratios.

Samuel Theodore
Managing Director
Moody's Investors Service
SN No:1470-5494 All rights reserved. No part or portion of this public permission of the publisher. Whilst every effort has been made to en


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