Press Release - Monetary policy and the euro area banking system - Speech by Peter Praet, Member of the Executive Board of the ECB, at ECMI Annual Conference, Brussels, 9 November 2016
The euro area banking system today is stronger than when it entered the financial crisis.[1] At aggregate level, risk-weighted capital ratios have steadily improved – the median Tier 1 ratio of euro area banks almost doubled since 2008 – while banks have reduced assets and raised equity, leading to a marked decline in leverage. Resilience has been further buttressed by a reduced relative reliance on wholesale funding – which proved particularly run-prone in the early stages of the financial crisis – in favour of a greater share of deposits in their liabilities.
But building resilience has been a long and hard-earned process, bolstered by public support – in the form of capital support and guarantees – at its peak amounting to as much as one and a half trillion euro in gross terms. And though the sector is now stronger and more stable, it is also facing major challenges in terms of earnings capacity and profitability.
The return on equity of significant euro area banking groups still remains well below their cost of capital. Market valuations point to an expectation of subdued earnings prospects going forward. And further signs of weakness have emerged in response to the different episodes of financial market turbulence since the start of 2016, which saw euro area banks’ price-to-book ratios particularly hard-hit.
This troubling picture can be explained by four interlinked challenges.
The first is the legacy challenge bequeathed by the euro area’s twin crisis, in which the financial crisis morphed into a sovereign debt crisis and a double-dip recession. This has left a legacy of persistently high levels of non-performing loans (NPLs) in parts of the euro area, which drive down bank profitability through loan-loss provisioning charges. NPLs also hamper the contribution of the banking system to the recovery in parts of the euro area economy, which in turn leads to weaker macroeconomic outcomes and still slower balance sheet repair. Question marks over how and when these NPLs will be resolved do little to improve the situation.
Second is the cyclical challenge posed by the low growth and low inflation environment, which goes along with lower levels of policy interest rates. So far, low rates have not had a marked effect on bank profitability, with net income actually increasing between 2014 and 2015. But with interest rates expected to remain “low for long” in the euro area, market analysts expect a significant reduction in (already low) returns on equity over the next five years, especially for banks whose business models are strongly reliant on maturity transformation. The relatively subdued growth outlook is also expected to weigh on credit demand and hence income growth from loan volumes.
Structural challenges are a third factor in weak profitability. Though the efficiency of the euro area banking sector has improved since the crisis, with median cost-to-income ratios declining by almost 10 percentage points, operating costs remain high in some national banking systems, especially those which are characterised by overcapacity. Banks with high fixed costs are also facing increasing competitive pressures from non-banks and new FinTech entrants. While there has been some industry consolidation in response, it has largely taken place within countries, meaning higher efficiency has come at the cost of increased national concentration.
Further rationalisation of branches and consolidation of entities appears necessary. But in a truly integrated euro area banking sector, what I would ideally like to see – as a medium-term goal – is such consolidation to go hand-in-hand with greater geographical diversification. Which is to say: banks achieving economies of scope and scale from cross-border mergers and acquisitions, while also deepening macroeconomic risk-sharing by diversifying country risks. This is, in my view, the litmus test of whether we have completed a genuine banking union.
Fourth are regulatory challenges. The increased resilience of the euro area banking sector is in large part down to the regulatory agenda since the crisis, but it is hard to deny that this agenda has also created some uncertainties, for instance over steady state capital levels, which are reflected in bank share prices. Regulatory constraints have had a direct impact on earnings capacity too, especially in the investment banking space. Revenue generation from fee, commission and trading income has fallen significantly as a percentage of assets since the crisis. This is a welcome and intended consequence of restrictions on excessive risk-taking, but comes at a time when interest income is also being compressed.
The slump in bank profitability is not, per se, a concern for policymakers. The banking sector needs to adjust to a changing market environment just like any other economic sector. But – as I will explain in today’s speech – the struggles of banks are not innocuous from a monetary policy perspective given their integral role for monetary policy transmission and macroeconomic performance more generally. And the newfound financial resilience of the euro area banking system can only be sustained if it is accompanied by improved financial performance in the future.
So the situation needs close attention and the risks must be carefully monitored. But in my view, the path towards a more healthy and sustainable sector involves a clear division of responsibilities.
Monetary policy will continue its accommodative stance until inflation returns to our aim, which will remove some of the cyclical drivers of weak profitability linked to disappointing nominal growth. This will require interest rates to remain low for an extended period of time. As such, it is urgent that, in parallel, steps be taken to address the other challenges depressing profitability: tackling legacy NPLs, responding to structural change, providing regulatory clarity. Such a comprehensive approach means both private actors and other policymakers must play their part.
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