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Looking forward, there are several ways of estimating what could be “realistic”, longer-term ROE targets for banks. In terms of historical comparison, we need to bear in mind that high leverage observed in pre-crisis years can flatter measured profitability. Therefore, an upper bound estimate for ROE targets could be derived by multiplying pre-crisis return on assets (ROA) ratios by the current, structurally lower leverage multiples. From another perspective, the long-term average of banks’ estimated cost of equity (i.e. the rate of return investors expect from an investment in bank equity) is a useful benchmark. In addition, survey-based information on banks’ own estimates of long-term sustainable ROE can complement approximations of what could be sustainable levels of profitability. Combining estimates from these different approaches, we arrive at a target range of 8-10% ROE for euro area banks.
Should we expect banks’ profitability to reach their “sustainable” targets over the next 3-5 years? Even in a benign scenario of a robust economic recovery, this may not necessarily be the case. For instance, in its latest Global Financial Stability Report, the IMF argues that even in a cyclical upturn, many euro area banks may not be able to raise their profitability to a sufficient degree.
Against this backdrop of cyclical and structural challenges to banks’ profitability, possible solutions include: (i) revenue growth; (ii) cost efficiency improvements; (iii) consolidation through mergers and acquisitions; and (iv) NPL resolution.
The first avenue that banks may want to explore is to revisit their revenue growth strategies, particularly in the field of fees and commissions that still show relatively low levels in international comparisons.
Adjustments to the business model could also include actively targeting a change in the product mix, seeking adjustments to the funding structure or increasing the geographic diversification of activities.
These discussed strategies have limitations, as they require capital, entail risks or on account of competitive pressures. From a financial stability perspective, one should also be mindful of the possible impact of revenue diversification on bank performance and riskiness.
As highlighted earlier, many euro area banks continue to operate with relatively high cost levels, which constitute a drag on efficiency and hamper the sector’s ability to generate sufficient net income. Improving cost efficiency is therefore another strategy some banks should pursue in order to return to more sustainable levels of profitability.
Cost reductions and efficiency improvements can be achieved in a variety of ways, ranging from more traditional measures such as downsizing, branch closures to the adoption of new, cost-saving technologies aiming at digitalising financial intermediation services such as increasing the reliance on internet-based banking. There is significant room to improve cost efficiency among euro area banks considering that the ratio of costs to total assets is, on average, 1.4% for euro area banks, and just half of that, 0.7%, for Swedish banks.
Apart from potentially reducing costs, a higher reliance on digitalised forms of financial services may also result in more contestable bank retail markets, as it becomes easier for bank customers to “shop around” and compare bank products and prices.[4] This, in turn, may have a positive impact on the sector’s overall efficiency.
It should be acknowledged though that cutting costs is easier said than done. It may entail substantial upfront investments and costs (e.g. new IT systems, compensation for staff reductions), may be hampered by country-specific legal and institutional settings and may be surrounded by non-negligible execution risks. The more capital-constrained banks especially may therefore face difficulties undertaking radical cost reduction schemes.
Another avenue towards improving efficiencies and eliminating redundancies is through banking sector consolidation via mergers and acquisitions (M&A). Well-managed M&As can deliver important cost synergies (e.g. lower administrative expenses, branch rationalisation) as well as revenue synergies (e.g. lower funding costs of the merged unit) that might contribute to improving the banking sector’s profitability prospects.
M&A activity has, however, remained subdued in recent years, in particular cross-border M&As. In the ECB’s latest Financial Integration Report, we document that M&A activity in the euro area banking sector has been on a declining trend since 2000, and in particular in the aftermath of the crisis. This is especially true as regards cross-border mergers.
In general, there is an ambiguous relationship between consolidation and financial stability. Banking sector consolidation could strengthen the market power of the merged entities which may help them restore profitability.
At the same time, by lowering competition, consolidation may increase the costs of retail financial services for households and firms and may also provide disincentives to keep costs under control. These negative effects are likely to be more pronounced in the case of domestic M&As, whereas cross-border mergers should be broadly neutral in terms of immediate impact on market concentration.
In this context, let me reflect on the Italian perspective. The Italian banking sector is one example among euro area countries where there seems to be scope for further consolidation. Indeed, in terms of standard concentration measures the Italian banking sector is among the least concentrated in Europe.
This has been duly recognised by the Italian authorities, which in recent years have introduced a number of measures aimed at consolidating and modernising the Italian banking sector, such as the reform of the mutual banks, the reform of the cooperative banks, and the self-reform of the banking foundations.
These are important steps to facilitate further consolidation of the sector which are welcomed in Italy and elsewhere in the euro area.
Excess capacity and fragmentation along national lines are, to some extent, hampering the profitability and performance of some euro area banking sectors. The banking union, including single supervision and resolution mechanisms, in principle provides ideal conditions for banks to reap the benefits of new cross-border merger and acquisition opportunities.
However, progress in both domestic and, in particular, cross-border bank consolidation remains limited to date. Ultimately, the euro area economy needs banks that are large and efficient enough to operate and diversify risks on a cross-border basis within a European single market, but small enough to be resolved with the resources of the Single Resolution Fund. This would make the most of the banking union while improving the trade-off between financial stability and economic efficiency.
One potential deterrent of further consolidation at the domestic and euro area level is the high NPL stock that I just mentioned, which may reduce the attractiveness of potential targets in some jurisdictions. This is another reason why resolving the NPL problem is of utmost importance.
Resolving the NPL problem
Resolution of the NPL problem is first and foremost a task for the banks. Should NPL markets be fully efficient, it would be straightforward to sell the NPLs to other investors. We know however, that the NPL markets in the EU are shallow. Notwithstanding the recent pick-up in transactions, only a small fraction – less than 10% - of the stock of EU NPLs changed hands over the last twelve months.
Notwithstanding the existing obstacles, a wide range of solutions to the NPL problem is available to banks and policy-makers.
Internal work-out would always feature among the available tools. In this vein, ECB Banking Supervision has recently issued guidance to improve bank capabilities in working out NPLs, as these vary significantly. Direct sales could be complemented by securitisations, asset management companies, and NPL trading platforms that may be used to transfer the risk of NPL work-out outside of the banking sector to those who may be better suited to recover value.
Clearly, more needs to be done to fully unlock the potential of market-based solutions to the NPL issues. Due to asymmetric information between the investor and the seller of NPLs, and to very long duration and high cost of debt enforcement procedures, there is a wide bid-ask spread in the NPL markets. The exact data on that gap are difficult to come by. Estimates suggest that it might reach up to 40% for a fully collateralised loan.
Reduction of that gap, which has many causes, requires a comprehensive strategy. Determined structural reforms should play a prominent role in the action plan for national and European authorities, regardless of the actual solutions adopted by individual countries.
For instance, debt enforcement procedures should be streamlined, and their cost lowered. This may require in particular that judicial and out-of-court capacity is increased. To mitigate the information asymmetry, access to financial information about distressed debtors and public data registers should be made easier. Investment in improving quality of that information is often needed, and may be rewarded by investors with higher transaction prices.
Within the comprehensive strategy, there may be a role for national governments to support the correction of the NPL market failure. Necessary structural reforms may require a lot of time to yield fruit and to earn credit with investors. This is a very tangible issue also in Italy, where recent reforms of the debt enforcement claims have not yet produced the expected results, and therefore have not influenced NPL prices to the desired extent.
Asset management companies (AMCs) may aid in correcting the market failure. They can swiftly clean up NPLs from bank balance sheets, and resolve them over a longer period of time. Acquisition of assets at their long-term economic value, instead of market value which is depressed by low liquidity and high uncertainty, minimises fire sale losses. Sweden, Germany, Ireland, Spain, Slovenia and Korea, for example, used these tools to manage their banking crises, often with a focus on loans backed by real estate. There is one common feature in this type of AMC: state support. By putting capital and funding guarantees at stake, governments can signal their commitment to the structural reforms and bring forward the related benefits. A similar role may be played by securitisation schemes.
The EU legal framework does not close the door to setting up an AMC with government sponsorship. The rules also allow for precautionary recapitalisation of banks by the public sector in cases of significant financial stability concerns, subject to strict conditions laid down in the BRRD (Art. 32, 4), covering hypothetical losses estimated under an adverse scenario of a stress test. Precautionary recapitalisations also have to respect State Aid rules that generally require bail-in of subordinated debt as stated in the European Commission’s communication of July 2013, where possible exemptions are nevertheless foreseen (paragraph 45).
Let me remark here that, in the steady state, this would not be a major issue as “bail-in-able” debt would in principle only be sold to knowledgeable, qualifying investors, capable of understanding the related risks. That unfortunately, is now not the case: our resolution rules entered into force before the requirements for MREL i.e. the specification of “bail-in-able” securities, entered into force. However, the rules give scope to address valid concerns about retail investors through compensation. The European Commission recently announced what could become an important initiative: a proposal regarding a comprehensive strategy to deal with NPLs in Europe, including a blueprint for national AMCs accompanied by a clarification of the regulatory aspects involved.
The new European Regulation on recovery and resolution deserves full support as it represents a change from easy public bailouts to a new culture of private bail-in, minimizing moral hazard. Notwithstanding this, the regulation does not ignore financial stability considerations. “We have to bear in mind that it is not only direct public support for banks that has a cost for taxpayers, but also financial instability – indeed, the costs of the latter may, in some circumstances, be higher. Compare the worldwide costs for taxpayers stemming from the absence of public intervention to rescue Lehman Brothers, with the zero cost for taxpayers following the USD 700 billion injection into U.S. banks in 2008 (which have been totally repaid by the banks). In other words, financial instability can have a meaningful cost to taxpayers even if it is not visible in the very short-term – a notion that all policy-makers should keep in mind. [...]