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SSM thematic review of profitability and business models

Frequently asked questions

Why have you conducted a review of the profitability of banks? Hasn’t the economic situation of banks in the euro area improved recently?

Despite the fact that the economic situation of banks in the euro area has improved, profitability and business models still remain under pressure. The thematic review was conducted to assess in more depth the drivers of profitability and the banks’ ability to steer strategically their business models, as well as to monitor the consequences of weak profitability for banks’ risk-taking behaviour. The findings from the firm-level analysis performed feed into the business model assessment in the Supervisory Review and Evaluation Process (SREP). The SREP involves a comprehensive assessment of banks’ strategies, processes and risks, and takes a forward-looking view to determine how much capital each bank needs to cover its risks.

Does ECB Banking Supervision take a stance on business models and their profitability? Is it not for market forces to decide on the success or failure of business models? Would forcing an increase in profitability result in a higher risk profile of banks?

ECB Banking Supervision assesses the viability and sustainability of banks’ business models without taking a stance on the various business models that coexist. This is in line with the Guidelines on common procedures and methodologies for SREP and supervisory stress testing issued by the European Banking Authority (EBA) . Our analysis within the scope of the thematic review also confirms that banks can be profitable across different types business models, and that strategic steering capabilities are an important factor influencing the profitability of institutions. Market forces may drive banks to increase their profitability. However, as supervisors we monitor the sustainability of an institution over the cycle. The supervisory expectation is that banks should have strong strategic steering and risk management capabilities.

What are the key weaknesses of banks when it comes to tackling low-profitability challenges?

The thematic review investigated the strategic steering capabilities of significant institutions, which cover the management’s ability to set a course towards the bank’s long-term objectives. The analysis was structured across several areas: net interest income, net fee and commission income, net trading income, operating expenses, loan pricing and strategy. We have identified some process deficiencies in these areas. For instance, in many cases, banks did not allocate costs to a business line or distribution channel. They also need to improve the governance around the strategic planning processes, which calls for more involvement of the risk management function, a clearer linkage to risk appetite and a more comprehensive sensitivity analysis of profit and loss drivers. In addition, loan pricing overall needs to be enhanced. Most banks need to develop a more comprehensive pricing framework and apply it consistently across the organisation. This includes consideration of minimum thresholds in loan pricing decisions. In general, banks with better strategic steering capabilities have generated higher relative returns over the last three years.

Do banks in some countries do better than those in other countries? Do some banks suffer from low profitability because there are too many banks in their country?

The profitability situation differs widely across institutions. Banks that have outperformed others over the last years are geographically spread out and have differing business models. Over the last decade some consolidation has taken place within many euro area banking markets. However, some markets remain fragmented. Banks need to earn a sufficient return on their capital to be sustainable. They need to review their business models and some might become leaner as a result, while others might merge and others still might fail.

Is there a link between your recent guidance on non-performing loans (NPLs) and the review of profitability? Will the results of the review underpin your approach to NPLs?

The profitability of directly supervised large banks is being challenged not only by high impairments, but also by legacy issues and pressure on revenues from the economic environment, low interest rates and high competition. NPL stocks are decreasing in most countries. Nevertheless, the current aggregate level of NPLs remains far too high by international standards. The ECB recently announced further steps to address the stock of NPLs, such as setting bank-specific supervisory expectations for the provisioning of NPLs. The aim of these steps is to ensure continued progress towards reducing legacy risks in the euro area and achieving the same coverage of the stock and flow of NPLs over the medium term.

Do you see an impact of low interest rates on bank profitability?

The macroeconomic environment characterised by low interest rates has left its mark on banks’ business models. The accommodative monetary policy has eased the pressure on the cost of risk and supported loan growth, but has also contributed to a squeeze of net interest margins. Nonetheless, net interest income has declined only modestly over the last years for most of the significant banks, as loan growth has compensated for most of the margin compression.

Why are banks in the United States more profitable than their peers in the euro area?

After the financial shock in 2007-08, US banks quickly cleaned up their balance sheets and built up capital with state support. They also benefited from relatively strong economic growth, which thus increased their assets, and managed to achieve pre-crisis profits by 2013. The US has also benefited from decades of national banking sector consolidation following the removal of barriers to interstate banking. Euro area banks took longer to bolster their capital levels and continue to address non-performing loans. Furthermore, in the euro area the economic recovery has been less pronounced than that in the United States.

Have you also analysed the impact of financial technology on the profitability of banks? Are banks taking digitalisation seriously enough?

The vast majority of significant banks have made digitalisation a strategic priority or are dealing with the topic at the boardroom level. However, the engagement varies widely across banks: while almost all banks aim to offer online and app-based distribution channels to their customers, many are also following a more integrated approach and are actively pushing digital transformation throughout their organisation.

Are you satisfied with the banks’ internal set-up to steer profitability? What can banks do to improve their profitability?

The thematic review of profitability and business models has identified differences in the quality of banks’ internal set-up to steer profitability. In general, banks with better strategic steering capabilities have generated higher relative returns over the last three years. Bank-specific recommendations were issued regarding the necessary improvements to strategic steering or risk management capabilities. The recommendations related to understanding income and expense drivers, cost management and allocation, loan pricing and strategy-setting processes. ECB Banking Supervision will monitor implementation of the expected improvements in strategic steering capabilities as part of the ongoing supervision.

How will this review inform the ongoing supervision of banks in the euro area? Will you be tougher on banks that follow a business model that is not profitable?

The findings from the firm-level analysis feed into the business model assessment of the 2018 SREP. In addition, the key conclusions and recommendations on process deficiencies were communicated to the banks in follow-up letters, including findings and expected measures. Throughout 2018 and 2019 ECB Banking Supervision will follow up on these findings. ECB Banking Supervision does not take a stance on the various business models that coexist and has focused during the thematic review on the significant banks’ strategic steering capabilities.

Will there be a follow-up report?

The topic of profitability is publicly discussed by ECB Banking Supervision via different channels (e.g. in its Supervision Newsletter, in speeches by Supervisory Board members). The report published today summarises the results of the thematic review undertaken to address one of the current supervisory priorities.