Past and future: a mixed picture for profitability

Banks are in the business of making money, earning a profit margin on the services they offer and the credit decisions they make. They either put this money back into their business through retained earnings or return it to their shareholders and investors. Supervisors closely monitor banks to ensure the risks they take are prudent ones. But supervisors also monitor how profitable banks are, how well they deal with costs that affect them individually and how they cope with developments that may pose a challenge for them (and their competitors).

As part of its ongoing analyses, each year ECB Banking Supervision asks the significant institutions it supervises how they forecast their own profitability. This year’s results show that banks expect profitability to improve gradually after 2017, with the aggregate return on equity (RoE) reaching 7.4% in 2019 against 3.4% realised RoE in 2016. However, only 25% of these banks expect to reach at least 8% RoE by that time. This means that in the medium term, profitability is likely to remain an issue for a number of euro area banks. It’s worth noting that the low average RoE in 2016 is not necessarily a reflection of poor operating performance. The number includes some one-off items–balance sheet repair and sales of non-performing exposures undertaken by certain banks–that resulted in additional provisioning and necessary increases in capital to cover related losses.

Banks’ profit forecasts rely primarily on two factors. First, based on the expectation that economic conditions in the euro area will normalise, banks anticipate, on aggregate, a 40% decrease in impairments and a growth in lending of around 11% between 2016 and 2019. They expect this loan growth to be strongest in international lending, to be evenly distributed across retail and corporate business, and to be lowest in domestic mortgage books. Second, the banks expect a shift in their income mix with, on aggregate, a 15% increase in fees and commissions and a 7% growth in net interest income between 2016 and 2019.

At the same time, their projections for operating expenses vary widely. The expected moderate decrease of 5% in operating expenses across the significant institutions between 2016 and 2019 is driven by large-scale cost-cutting schemes at a small number of banks. Excluding these, the “average” bank expects costs to be stable over this period. In general, banks plan to spend more on IT and less on branch networks. Overall, the ECB’s latest profitability forecast exercise showed that banks see a brightening outlook. However, back-testing forecasts from previous years indicate that their average RoE predictions may in fact be somewhat optimistic.

In recent years, the profitability of ECB-supervised significant institutions has shown a picture of contrasts. On the whole, the picture seems gloomy, given the average RoE of 3.2% in 2016, compared with 4.4% in 2015. At the same time, however, 24 significant institutions from 12 euro area countries are consistent outperformers, posting an average RoE close to 10% over the past three years. While there is no magic recipe, the feature most of them have in common is higher operating efficiency and lower-than-average cost/income ratios because of above-average capabilities to generate revenue and/or tight cost control.

But alongside these top performers, many euro area banks need to continue adjusting their business models. In some cases, the figures suggest that they are already implementing clear strategies, including, for example, the expansion of business, leading to strong growth in income and costs; streamlining to cut costs while keeping income stable; or deleveraging to cut costs and strengthen their balance sheets. Nevertheless, most banks do not seem to have advanced far along this road.

Given the mixed picture regarding actual profits, banks’ own forecasts and the varied performances of individual banks, supervisors are careful not to analyse the profitability of euro area banks with a one-size-fits-all approach. In the coming months ECB Banking Supervision will continue to analyse profitability and business models as part of its ongoing bank-level supervisory activities and horizontal analyses identifying big picture trends, and will also conduct a thematic review of profitability.