10 December 2019

European Parliament: The main factors for the subdued profitability of significant banks in the Banking Union

This paper surveys some recent studies on the causes of low profitability, and discusses several actions that the SSM may want to undertake to support banks in their quest for higher returns.

Most significant institutions in the euro area generate returns below the risk-adjusted rate required by investors. Best performers have invested in IT, and improved efficiency by expanding revenues; meanwhile, low-profitability banks have been struggling with legacy assets and a weak income-generation capacity. Negative market rates have made retail deposits less profitable, while leading to an increase in lending volumes and to lower loan-loss provisions. Banks burdened by low profitability have less room to invest in digitalisation and in the maintenance of legacy systems, putting their long-term survival at risk.

According to ECB top officials, mergers and acquisitions may improve the industry’s overall profits, although there is no clear evidence that large institutions enjoy consistently higher returns. Nevertheless, smaller institutions would likely benefit from consolidation, although the role of “community banks” should somehow be recognised by ad hoc regulations.

A significant gap emerges between euro area banks and their US-based counterparts, as the latter are less encumbered by non-performing assets and enjoy higher customer-related margins. Additionally, the US have benefited from bolder policies after the 2007-2009 crisis, with equity capital and cheap liquidity being quickly injected into the banking system.

Euro area banks may need short-term support to preserve net interest income in an era of low growth and negative interest rates. To this aim, some form of targeted capital relief may be devised for new loans meeting minimum quality standards (including forms of environmentally-conscious lending).

The main factors affecting bank profitability (the real economy, which in turn drives monetary policy, regulation, competition, excess capacity and digitalisation) are mostly beyond the supervisors’ remit. Still, the latter may put in place several actions to support banks in their quest for higher returns.

First, they should not prevent lenders from embracing higher-risk businesses that generate additional returns. Once banks have in place adequate risk management systems, capital and liquidity, they should not be restrained from investing e.g. in speculative-grade loans, or in the management of non-performing exposures, which will otherwise accrue to an ever-growing shadow banking system.

Secondly, supervisory decisions should become timelier and more predictable. Greater disclosure on the contents and motivations of decisions regarding individual banks would help set clear precedents that other lenders can use to calibrate their expectations on future supervisory responses. Improved coordination among supervisors regarding guidelines and data requests would also help, by minimising the risk of conflicting interpretations and overlapping demands.

Finally, the SSM should refrain from using capital add-ons as a remedy against non-financial risks, i.e., as a substitute for non-capital related measures, which ends up depressing leverage and return on equity. To this to occur, however, European lawmakers may have to enhance the ECB’s intervention powers, e.g., in areas like the removal of unsuitable directors.

Full publication on EP

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