Solving a problem like Europe’s banks

European banks are in serious trouble. Stuck in an environment with low growth and lower interest rates, they are struggling to build capital while their US-based competitors have so much they are handing it back to investors. Throw in underperforming investment banks and long neglected legacy loans and the continent’s financial sector looks troubled indeed.  But that doesn’t mean nothing can be done. Belated efforts to harmonise the treatment of banks across Europe, a single supervisor and perhaps a deposit government guarantee scheme represent the efforts of the official sector. 

From the private sector, a growing financial technology industry is an opportunity as much as a threat — if banks can move decisively away from their burdensome branch networks, their costs could plummet even as their underwriting and services improve.

Monetary policy is going nowhere fast, which can help and hinder bank returns. The first round of extraordinary liquidity support in the shape of the TLTROs (long term refinancing operations) acted straightforwardly on the cost of bank liabilities — cheaper funding from the central bank meant improving margins.

But the second round of ECB easing, based on asset purchases and breaking through the “zero lower bound” to a negative deposit rate, looks set to be more damaging. 

The ECB buys bonds from banks, the mark-to-market of their liquidity books improve, but without economic growth and household releveraging, there’s nowhere to put the cash. Banks with big deposit bases also struggle since most institutions are unwilling to charge customers to deposit money so deposit liabilities have to pay 0%. 

Some banks have overhauled fee structures for current accounts, aiming to recoup some of the difference, but in the new world of European interest rates term wholesale funding from the central bank comes in cheaper than overnight funding from retail. There’s no real reason left to be a retail deposit bank.

On the asset side, banks like other investors can look to extend maturities (but the yield curve is flat), find riskier investments (but capital charges will hurt them) or lever up (but they’re not allowed to).

It’s not a problem that banks can think their way out of. Some institutions have turned to new management in times of trouble — the return of Jean-Pierre Mustier to UniCredit is a fine example — but there’s no way around it: the business of banking relies on borrowing short and lending long. A flat yield curve means they make less money.

“Compared to the start of the financial crisis in 2008, banks are in a different situation now to in the middle of the crisis and banks have much more capital,” says Koos Timmermans, vice-chairman of ING’s management board. “But banks do have to deal with an economy where credit demand is rather low and the ECB extending balance sheet means low interest rates, low credit spreads and low earnings of banks.”

DISUNITED EUROPE

Though every financial institution in the eurozone is struggling with the same exceptionally low rates, the different national market structures — and the heavily divided European banking market — means reactions to the difficult monetary climate are very different. 

For example, German private sector banks, such as Deutsche Bank and Commerzbank, cannot squeeze more profit out of their retail divisions easily because so much of the market is served by not-for-profit institutions such as the savings banks.

In France, meanwhile, structurally high loan-to-deposit ratios have flipped from a weakness of the system to a strength. While wholesale funding was scarce and expensive during the crisis, it made French banks vulnerable to investor runs (the dollar squeeze in 2011 was precipitated by worries about whether Sociéte Générale could access the market). But now deposits are floored at zero, wholesale funding is abundant and there’s a shortage of investment opportunities, a high loan to deposit ratio looks like a strength.

LOWER FOR LONGER

If interest rates go back up it won’t matter too much. For banks with non-core assets or large books of mark-to-market bonds, the low rates deliver a temporary boost.

“The low yield environment works on both sides of the balance sheet but unevenly,” says Michael Reuther, chief executive of Commerzbank’s corporates and markets division. “It helps to achieve higher prices for the disposals of non-core assets but it has a larger negative effect on the net interest margin you can achieve and on maturity transformation of deposits. The non-core disposals are a one-time effect while the effect on the deposit margin is an annuity.”

But prolonged low interest rates beyond two or three years will cause serious problems for all of Europe’s banks.

“Eventually, however, low interest rates will take their toll on banks,” said Danielle Nouy, chair of the supervisory board of the European Single Supervisory Mechanism, speaking in Bratislava in September. “High yielding fixed rate loans will either mature or be repaid and be replaced by lower-yielding assets, which will decrease net interest income. At the same time, the gradual decline in interest expenses borne by banks will come to a halt as they will be reluctant to charge negative rates on deposits.”

“You could say, even if interest rates are extremely negative, what does it matter so long as the money you take is at a lower rate than you lend out?” says Timmermans. “But if your liabilities are stuck at zero you get a mismatch, and if it’s prolonged it will have a real influence on profits.”

DIGITAL ESCAPE

When revenues are under pressure, most industries look to cut costs and the banks are no exception. Europe’s big banks, with extensive wholesale and investment banking operations, have already been slashing staff in their expensive trading divisions but cost control is crucial in retail as well.

At its simplest, that means cutting staff and closing branches. In certain countries such as Italy, the oversupply in bank branches is chronically bad, with 59 branches per 100,000 adults at the last count (the UK has 25; tech-savvy Estonia just 12).

But you can’t cut your way to success and the great hope of the industry is that digitisation will save the banking industry by drastically cutting the costs of engaging with customers. Banks will become risk managers and capital providers behind the scenes of a one-stop, click-to-buy financial services boutique.

“One way to address the weakness in profitability is the further industrialisation and digitalisation of all processes,” says Reuther at Commerzbank. “Before the crisis, when revenues kept growing, banks saw no need to re-engineer their operations but that time is over.”

“Digitisation has led to clients doing some of our work for us,” says Timmermans. “Ten years ago, we’d spend time filling in cheque details and copying information. Now clients will do it all via mobile phone.”

For different firms, though, this means different things. Johannes Rehulka, general secretary of the Austrian Raiffeisen banks association, representing more than 500 smaller institutions, argues that customers will continue to want to make their largest financial commitments in person.

“If the client tells us in the future that he wants to digitise everything then perhaps banks can do that,” says Rehulka. “But personally I think it won’t be that extreme, I think there will be a strong desire remaining to talk to someone personally, especially about the larger decisions. For many people a €300k mortgage is the largest financial decision they will ever take and before they take it they will want to talk and to inform themselves.”

Digitisation doesn’t just mean buying banking products online. Banks have huge volumes of data on their customers, which often goes untapped. But machine learning techniques hold out the possibility of better credit scoring and better anticipation of a customer’s needs. Just because retail customers aren’t personally known to their branch managers any more, that doesn’t mean banks can’t offer a personalised service.

In wholesale divisions, too, digital banking should mean more than a web interface with a dealer’s axes on. It means banks licensing automated trading capabilities to clients, syncing up back office and settlement and having a real time view of risk appetite and revenue potential.

Reuther adds: “It’s not just about having a fancy app for your customers, it’s about fully digitalising front to back in the next three to five years at the most and therefore achieving much lower costs for sales and distribution.”

MERGING TOO SLOWLY

Though it promises a transformation of the industry’s cost base in Europe and elsewhere, digital banking can only go so far. Europe is still overbanked, many institutions are not competitive and capacity needs to come out of the industry.

One way to make this happen is through mergers. Europe’s advisory bankers have been hoping for a FIG M&A boom since the hasty and unwise tie-ups of the 2007-09 era but progress has been achingly slow. Some of Spain’s undersized Cajas were forced together in regulator inspired shotgun marriages and some of Germany’s larger Landesbanks gobbled up their smaller peers. Italy is still lagging behind, though a law forcing corporate governance changes on its co-operative sector, passed in April, might change that.

“I don’t think merging can be the only solution for the whole banking sector,” says Rehulka. “It’s absolutely not the right vision to establish only a few big banks, absolutely not the vision. Lots of small and medium banks give you a diversification of risk.”

There’s certainly been little cross-border consolidation to create new megabanks. Banks with major subsidiaries in other European countries have drawn their horns in. Barclays sold its Spanish and Portuguese credit card businesses and its Italian mortgage lender. Crédit Agricole extracted itself from its hapless Greek subsidiary Emporiki for the price of a single euro and ING closed its UK mortgage operation. Right across Europe, institutions have renewed their focus on their core markets.

SUFFOCATED BY REGULATION

But the main obstacle to consolidation has been regulation. Reuther says: “I expect consolidation in the mid-tier of the banking sector at a certain stage. After the AQR [Asset Quility Review] and the EBA [European Banking Authority] stress test in 2014 was actually a good opportunity because you could not have asked for a better due diligence but the uncertainty caused by rising regulatory demands stopped it. Once FRTB [fundamental review of trading book], Basel IV and the other regulatory initiatives are finalised and the dust has settled, I would expect to see consolidation on the agenda again.”

To calculate whether a merger makes sense, it helps to know the end state of regulatory capital requirements.

HAND THE MONEY BACK

The other option to take capacity out of the industry is returning capital to shareholders. 

“Should it always be consolidation that takes away excess productive capacity?” says Timmermans. “Returning money to shareholders is another way of taking capacity out of the industry. Clearly you need to meet your regulatory minimum levels, but beyond that you can see shareholders wanting 100% or more returned to them.”

For some European firms that’s a distant dream. Speculation is still rife that Deutsche Bank will need its fourth post-crisis rights issue in the year to come, while some analysts expect UniCredit to go to shareholders for up to €10bn. The state-sponsored recap of the weaker Italian banks has only just got going.

But stronger firms further down the restructuring road are already thinking about how to pay out some of their restructuring proceeds. HSBC’s sale of its Brazilian unit prompted a $2.5bn share buyback programme, for example. If the European banking market is indeed too small to support all of the banks at an acceptable return on equity, better to hand the money back and admit that investors, not banks, can figure out how best to deploy it.

STOP THE TRAIN

Again though, regulation is likely to slow the process down. Senior bankers see the next round of Basel requirements, which are being calibrated this year and early next, as just the latest part of an unceasing treadmill of increased capital.

“If I could make one change to the regulatory framework, I would stop increasing the requirements for the different layers of capital and stop them changing over time,” says Reuther. “Regulators might demand a capital ratio of 15% or 20% but what we really need is the endgame, the final state.”

Even when the bald figures of capital targets aren’t increased through additional buffers or guidance, lots of the changes to supervision techniques, to “Pillar 2” (institution-specific) requirements and changes to asset calculation have all driven banks to hold more capital.

“Capital ratios in Europe have roughly doubled in nominal terms, but on a like-for-like basis European banks are carrying approximately up to 10 times as much capital as before the crisis,” says Reuther. “It’s a much better safety net but how can the industry know when the times of increasing capital requirements are over?”

A BASEL BOOST?

The new Basel rules have attracted particular ire, despite public statements from Basel Committee members that they won’t boost total capital requirements any further.

“There’s still a discrepancy between the figures in the Basel IV consultation, which show significant increases in capital, and the statements of regulators, which say there will not be an increase,” says Timmermans. “If we apply the currently proposed Basel rules, they’re clearly better for American banks than European or Asian. European banks have a different balance of business — more mortgages on balance sheet, for example.

The “capital floors” in Basel IV, which limit how much banks can cut risk weights using their own models, are the most serious part of the consultation for big banks like ING but even at the smaller end of the spectrum, regulation is proving a challenge since the Basel Committee is also revising the “standardised” approach to calculating risk.

“What all banks in Europe need is a regulatory respite,” says Rehulka. “We have implemented Basel III in 2014 with implementation timelines up to 2019. That’s no problem for banks but there’s an insecurity about whether these rules are final. Basel is already working on new requirements, which in turn will have to be implemented over time.”

ESCAPING THE TRAP

Fortunately, help might be at hand. Banks crossing their fingers and hoping for higher growth and higher interest rates will likely be disappointed but there are already strong moves to slow down regulatory change or even scrap some initiatives.

During the Basel Committee’s September meetings, several leaks to the press suggested a softer line across several asset classes — banks would be able to use a basic version of their own models to calculate corporate risk weights rather than scrapping them altogether while mortgages would receive better treatment than proposed last year.

There’s also a reduced appetite from European regulators to follow whatever is agreed at the Basel level slavishly. CRD IV essentially lifted Basel III unaltered but policymakers are becoming increasingly sensitive to bank lobbying about the “distorted playing field” and increasingly aware that the US is unlikely to implement the new Basel norms at all.

US banks argue their environment has its own flaws — the fines and legal settlements paid by, for example, Bank of America are over $80bn, a large multiple of the fines imposed on even the hardest hit European firm.

But that may not matter. The European Commission is reviewing all its regulation for proportionality and for anything which can be scrapped, while the Capital Markets Union agenda will serve partly as a cover for the relaxation of rules on securitization, infrastructure, liquidity and small business lending.