Joaquín Maudos, Chaired Professor of Economics at Universidad de Valencia. Deputy director of the Ivie and collaborator of CUNEF
A decade after the outbreak of the financial crisis of 2007, the health of the eurozone banking system remains a concern. One need only to look at the current level of profitability (3.1% Return On Equity, ROE) to confirm there is still a problem of feasibility, since the profitability investors demand is higher than the one banks can offer. The IMF warned about it in its 2016 Financial Stability Report, whose analysis of the European banking system estimated that almost half of the European banking business (specifically, 47% of it) was on the balances of weak banks, which are the ones that did not reach a ROE of 8% (estimate of the cost associated with attracting capital). The most worrying message of the abovementioned report is that even if we experience a recovery of the economic cycle and implement structural reforms, 18% of banking assets would still remain in weak banks.
There are three main reasons explaining the low profitability: a large stock of non-performing assets, a persistently low interest rate scenario (along with a flat rates curve) and the strong regulatory pressure, demanding more capital and liabilities with loss-absorbing capacity.
In the first case, in the balance sheet of European banks there is around one trillion euros in non-performing loans (NPLs) that are not generating any revenue, but which actually have a cost and consume capital. Italy has a large amount of those assets (298 billion euro) followed by France (150 billion euro), Spain (136 billion euro) and Greece (115 billion euro). As a percentage of the loans granted, Greece, Cyprus and Portugal have the highest default rates. The concern about the huge amount of “toxic” assets is such that a wide range of initiatives have been proposed to address the problem, such as creating a bad bank with public and/or private participation or facilitating the functioning of secondary markets for non-performing assets. The ECB recently published a guidance on NPLs, calling on banks to implement realistic and ambitious strategies for NPLs reduction. As declared by the outgoing Finance Minister of Germany and former President of the Eurogroup, Wolfgang Schäuble, “bad loans are a great risk for the stability of the eurozone”.
There is no doubt that the accommodative monetary policy of the ECB has delivered some benefits (both in quantity and price) in terms of improvement in access to financing, and that the first phase of interest rate cuts was a manna from heaven for the banks in the form of capital gains resulting from the revaluation of assets. However, once those rates have reached such persistently low levels (the twelve-month Euribor is negative since February 2016), the manna from heaven has turned into a nightmare, as it has placed the banks’ intermediation margins at levels of concern for the profit and loss account. This in addition to a flat rates curve, which suggests that the difference between the long-term interest rate at which banks lend money and the short-term interest rate at which they finance is very small.
The pressure that regulation exerts on profitability not only lies in demanding more capital and labilities with loss-absorbing capacity (which are expensive and difficult to place on the market), but also in the uncertainty of the date in which exigencies will end. Banks complain—and for good reason—of not knowing when the so-called “regulatory tsunami” (the III Basel Accord still needs to be completed) will end, since it is difficult to take decisions in a scenario of uncertainty.
Although slowly and going in hand with the recovery of the economic cycle, the profitability of the European banks is improving and non-performing loan ratios are reducing. However, in spite of the initiatives of the ECB, credit recovery is slow. The signs of monetary policy normalization are good news since it would contribute to a greater financial stability thanks to the recovery of banking margins. It is no use to continue penalizing banks with negative interest rates for their excess liquidity when the money placed in reserves above the minimum required and in the deposit facility has increased together with penalization. Therefore, with a penalization of 0.4%, the eurozone banks have currently reached an all-time high of € 1.9 trillion on liquidity excess. If banks decide to assume this cost, is because there is not enough solvent demand for financing by enterprises and families. In this context of low profitability, European banks must make an effort to reduce costs (average operational costs have increased since 2008) so that they can increase their efficiency (which has not improved since 2010), to which would contribute a consolidation of the sector (especially among banks from different countries, a pending subject which shows the barriers to integration incompatible with a single banking market) and an adjustment of its existing capacity (another pending subject in many countries). Moreover, as recently pointed out by the ECB, it is important to diversify the revenue sources and profit from the opportunities offered by digitalization. The good news is that capitalization made by the European banks in the last years means that only a reduced number of small banks will have solvency problems in the event of an adverse scenario.
In summary, to achieve the desired financial stability, the profitability of the European banks needs to recover. A part of the low profitability is due to temporary factors, but the other one is due to structural ones, notably the large amount of “toxic” assets. Completing the European Banking Union would also enhance stability, since its third pillar, based on a European deposit guarantee scheme, is another pending subject.