23 September 2021

SSM's Enria:The many roads to return on equity and the profitability challenge facing euro area banks

Banks’ profitability is a key driver of capital strength, financial stability and resilient financial intermediation. First, organic profits are the first line of defence against shocks to the economy. Second, banks’ ability to raise capital when needed depends on their profitability

I would like to focus my remarks on European banks’ profitability and business models.

Supervisors are neither bankers nor consultants. It is not our job to make decisions about banks’ business model strategies, corporate structures, business lines or risk appetite. Why then, do we venture into discussing the finer details of the quest for profitability?

Banks’ profitability is a key driver of capital strength, financial stability and resilient financial intermediation. First, organic profits are the first line of defence against shocks to the economy. Second, banks’ ability to raise capital when needed depends on their profitability. And third, unsustainable business strategies, such as gambling for resurrection or unhealthy pricing competition among banks, lead to an altogether riskier banking sector, threatening financial stability.

Whatever choices they make, banks need to ensure their business model performance is sustainable throughout the cycle, including in challenging business environments, such as those that followed on from the great financial crisis, the sovereign debt crisis and, more recently, the coronavirus (COVID-19) pandemic.

However, European banks have actually been struggling with low profits for more than a decade. In my speech today, I will review the cyclical and structural hurdles that have contributed to this. I will argue that the pandemic shock has prolonged the pressure on interest margins but has also created favourable conditions for a more radical revamping of business models and for restoring profitability to sustainable levels.

What levers do banks have to try and enhance their profitability? And are they pulling the right ones?

Asset quality has been a drag on European banks’ profitability for quite some time. We are glad to see that more decisive action has been taken in recent years to resolve the burden of legacy non-performing loans (NPLs). The massive progress achieved should not lead banks to lower their guard on credit risk, as the actual impact of the pandemic on asset quality has not yet become apparent. A recovery in profitability based on a sharp and sudden reversal of provisions might not prove durable if the optimistic expectations of banks do not materialise and, as public support is gradually phased out, the risk environment turns out to be worse than currently expected. Many banks have been longing for a normalisation of the interest rate environment as a panacea for restoring profits. It is now clear that the pandemic has extended the time frame for that adjustment. And even when it does occur, the new normal won’t look like the old normal. The digital transformation has accelerated during the pandemic and is changing the competitive landscape for good. Environmental, social and governance risks are growing in importance, reshaping the business environment and impacting on business strategies. At the same time, the regulatory overhaul that followed the great financial crisis rules out strategies boosting leverage and pursuing risk taking as shortcuts to achieving a higher return on equity.

The only serious way to address and win the profitability challenge is to take decisive action towards enhanced cost efficiency and to refocus the business model towards longer-term value creation opportunities. And this is where I become more optimistic. My take is that beyond what can be seen in the aggregate data on cost efficiency, which admittedly tells the story of sticky inefficiencies, there have been recent signs of concrete improvements, and more changes seem to be occurring than is generally acknowledged. Where there has been healthy pressure from shareholders combined with focused strategic steering from managers, we have seen more ambitious cost reduction programmes and transformation plans taking shape. The fact that upfront transformation costs have to be borne implies that results are often not yet visible in profit and loss (P&L) outcomes. But, with some delay, tangible improvements in cost efficiency and profitability can be achieved.

Bank mergers and acquisitions (M&As), generally considered the boldest and most transformative type of adjustment, seem to have gained some momentum in 2020 despite the pandemic. Beyond what we can see in aggregate M&A data, some banks have also engaged in more targeted consolidations at the line of business level as well as in other forms of business model optimisation. In the areas of asset management, custody and settlement services and payment technology, some players have been expanding or diversifying while others have been downsizing in order to redirect resources and refocus. Fully-fledged bank M&As remain predominantly domestic, but some of the more targeted transactions feature a cross-border dimension, thus also contributing to financial integration within the EU.

At the root of a long-lasting challenge

The profitability of euro area banks has come under significant pressure since the great financial crisis of 2007-08. Return on equity (RoE) hit its lowest point at the peak of the European sovereign debt crisis and took several years to stabilise at the 6%-7% average values observed during 2017-19 up until the pandemic shock. Absolute RoE values prior to the great financial crisis are not necessarily a good benchmark, as they stem from far lower capital levels than those we are seeing today, as well as attitudes and practices that no one wants to see return. However, as research published by the ECB^[1] shows, the great financial crisis does represent a structural break in that, since it occurred, the average euro area bank has been unable to earn the sector’s estimated cost of equity, which is commonly used to measure the compensation investors demand for investing in and holding bank equity (Chart 1, panel a).

A look at the comparative performance of global systemically important banks (G-SIBs) across jurisdictions shows that the post-crisis profitability adjustment has been steadier and somewhat faster in the United States than in Europe (Chart 1, panel b), although this trend can also be explained by EU-specific sovereign debt crisis events....

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