IMF: Breaking the bank? A probabilistic assessment of euro area bank profitability

22 November 2019

This paper attempts to shed light on the main determinants of the profitability of larger euro area banks using a novel approach. Specifically, the paper proposes a more probabilistic approach, which places greater emphasis on bank heterogeneity by focusing on bank profitability distributions.

To facilitate comparability with the existing literature, the paper first establishes the most reliable determinants of bank profitability across the largest euro area banks. Selected determinants are then shocked to assess how they differentially affect segments of the bank profitability distribution. Specifically, higher economic growth, or a lower NPL ratio, for example, may affect the center of the bank profitability distribution in a different manner relative to how they may influence the tails of the distribution. In this way, the approach in this paper goes beyond the standard comparative statics centered on averages in many studies, and can be particularly insightful.

The empirical analysis reveals that real GDP growth and the NPL ratio are the most reliable medium-term determinants of euro area bank profitability. A key insight of the paper is that although higher growth would raise profits on average, a significant share of banks in the weakest tail of the profitability distribution would most likely continue to struggle, even with a cyclical upswing. Therefore, some banks, in particular, should resolutely address their NPL stocks. In addition, evidence suggests that greater cost efficiency (through digitalization, for example) could enhance profitability of many banks. Although the results on business models were more mixed across all banks, revamping business models could improve profitability for some banks, suggesting the need for custom-tailored approaches.

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