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The future for the European banking sector is currently clouded in uncertainty. European banks are coming out of the crisis facing disruptive forces from all sides. They confront three main challenges to their business models.
The first is dealing with the legacy effects of the crisis on their balance sheets.
Since 2009 banks have been going through an arduous process of restructuring and deleveraging: shedding non-core business lines, writing down impaired assets and increasing provisions. This process has been costly both in terms of lower profits and diverted management time. Many banks also still have to work through their large stock of non-performing loans (NPLs), which further weighs on earnings prospects. Sufficient recovery from NPL resolution is hindered by slow national insolvency procedures for firms and an underdeveloped European distressed debt market.
The second challenge is adapting to the new wave of regulation since the crisis.
Banks have been required to improve both the quantity and quality of their capital, which has, in the short-term at least, led to a de-risking of banks’ balance sheets to improve risk-weighted assets. The incoming leverage ratio, which will put a cap on balance sheet size, is also obliging banks to make difficult decisions over how to allocate assets and which business lines to maintain. And reform proposals are on the horizon that will limit cross-subsidisation between banking and trading activities, which will require some adaptation in the business models of Europe’s universal banks.
Third, banks are faced with profound structural changes.
As evolving customer preferences interact with new technology, for instance in the growth of internet and mobile banking, barriers to entry into banking are falling. Banks with large branch networks are being exposed to competition from lower cost and less regulated operators. We see this already in the emergence of peer-to-peer lenders and technology firms offering banking services. There is also increasing competition in banking services more generally, as firms like Paypal become well-established in markets like retail payments that were previously the preserve of high street banks.
On top of this, the trend towards more capital market-based financing in Europe – supported by the new initiative on Capital Markets Union – will inevitably weaken banks’ market power, especially for firms that can easily substitute bank and market finance. And though still relatively small in quantitative terms, we are also seeing a greater role of “shadow banks” in direct lending – asset managers, pension funds, private debt funds – that heralds a shift towards a less bank-dominated financing mix.
Taken together, this represents a uniquely challenging environment for European banks, and this is visible in their generally weak financial performance: price-to-book ratios are low and profitability is meagre. Many banks have a cost of equity exceeding their return on equity. Moreover, there is little chance of the economy coming to the rescue or of interest rates rising any time soon. Banks will have to return to profitability in the context of a slow recovery with depressed net interest margins.
So, should we be concerned about how banks will fare in this difficult climate? As I already intimated, in my view we need to take a nuanced stance here that balances principle and practice.
In principle, the developments in the banking sector should be largely positive for society at large. Many banks grew too quickly before the crisis and developed unsustainable business models, so a period of consolidation is both desirable and inevitable. The aim of the regulatory agenda, which is to make banks more resilient and reduce the burden of bank failure on society, is also fully justified.
And the ongoing structural changes are welcome. If we believe in the benefits of creative destruction for normal firms, then we must also believe in it for financial firms. Innovation that raises competition in retail lending, and leads to better and cheaper services for customers, is a net gain for the economy. So, a priori, I do not see any role for regulators in protecting banks from new operators – on the contrary, innovation should be nurtured and encouraged.
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In my view there are three areas in particular where we could make improvements.
The first is by accelerating efforts to put the legacy of the crisis behind us.
For example, there is a great deal more that could be done at the national level to make NPL workouts more efficient, like improving intercreditor mediation or in- and out-of-court restructuring frameworks. To complete insolvency proceedings in Italy takes 1.8 years, while in Ireland it takes just 0.4 years. Pan-European initiatives could also play a role in reducing the legacy stock of NPLs, for example by adopting a centralised approach to speed up the pace of NPL write-offs.
The second area is advancing with the agenda to revive high quality securitisation in Europe.
Securitisation is where banks and capital markets meet – a well-functioning asset-backed security (ABS) market means more bank lending. There are many issues involved in reiving the market, which I have discussed at length elsewhere, but one of the most important is improving information for investors. The ECB is playing its part here through its loan-level initiative, and various credit scoring initiatives by national authorities are helpful. But over the medium-term I am convinced we need to work towards a pan-European central credit database. This would facilitate multiple country SME ABS, which in turn would reduce both the risk and price of issuance.
Third, I think it is now key to provide more regulatory clarity.
Regulators have put a large burden on banks and it has probably come at a cost. If banks are simultaneously having to lower costs while raising the resources they dedicate to regulatory compliance, there must be a consequence elsewhere. For instance, IT resources may be diverted away from innovation. We also still hear reports from market participants that regulatory uncertainty is constraining bank lending. It is therefore time to make clear how the future regulatory landscape will look.