Profitability numbers are looking up, but not enough

Profitability is a concern for banks and an issue that supervisors, too, need to take into account when assessing the viability and sustainability of banks’ business models. Moreover, profitable banks are more attractive to investors. They can increase their capital ratios by retaining earnings or accessing the markets directly – which can be critical when they’re required to adjust capital levels to meet future supervisory expectations. Profitable banks also have the means to invest in new technologies and sound risk management. However, there is one important caveat: consistent, exceptionally high profitability can also point to hidden risks, and supervisors will keep this in their sights.

ECB Banking Supervision has analysed banks’ profitability for 2018 in comparison with 2017. Supervisors looked at profitability drivers within and across the countries in which the Single Supervisory Mechanism (SSM) operates and in banks with comparable business models.

In 2018, the profitability of European banks improved slightly, on paper at least. But this improvement does not ease supervisory concerns, for two reasons. First, profitability levels are still low. Second, profitability, when expressed in numbers, only tells part of the story. To assess the sustainability of business models it is important to understand how banks’ bottom line profitability is achieved: are improvements backed by sustainable, stable components or are they the result of volatile, cyclical or one-off effects or even aggressive accounting policies? A closer look at the drivers of profitability in 2018 reveals a need for further research and constructive supervision.

Average return on equity has maintained a slight upward trend, improving from 6.1% in 2017 to 6.4% in 2018, much in line with banks’ own projections. However, this improvement is not sufficient to relieve the pressure on their business models. The profitability of banks in the euro area remains low; notably, lower than that of their US and Nordic peers. In many cases, it is also below their cost of equity, a concept that reflects stakeholders’ expectations about banks’ profitability. This is also reflected in the low valuations of most publicly listed significant institutions.

The most significant profitability driver in 2018 was lower net impairment flows from financial assets, which partly reflect the ongoing reduction in non-performing loans and a supportive macroeconomic environment. Historical data suggest that impairments are now at a level where there is little room for further improvement. In the coming years, banks will no longer be able to rely on lower impairment levels to improve profitability. On the contrary, recent economic developments suggest that it may be prudent for them to have higher impairments. Moreover, impairments can be volatile, and large one-off charges can completely change the picture. Therefore, a sustainable profitability path needs to be supported by improved operational efficiency instead. In 2018, however, operating profits slightly deteriorated.

On the upside, analysis shows that in 2018 core banking revenue – which comprises net interest income (NII) and net fee and commission income (NFCI) – reached its highest level since banks began reporting data under the SSM in 2014, with NII increasing by around 1.6% and NFCI by around 2.2%. At the same time, the volume of interest-bearing assets grew by more than 2%, accounting for most of the growth in NII. Margins, however, have been stable at best.

On the downside, the impact of this increase in core banking revenue was more than offset by a decline in more volatile trading income (by around 13.5%) and other operating income (by around 41.4%).

Meanwhile, the structure of lending has been changing: 2018 saw a reduction in lending to the public sector (including central banks) and an increase in lending to financial companies, corporates and households.

Any analysis of banks’ profitability drivers must also look at costs. Sizeable cost-cutting had been foreseen but, on aggregate, operating costs marginally increased in 2018. That said, higher administrative costs were in many cases warranted by the need to invest in digitalisation and new technology to generate income or achieve cost savings over the medium term. Overall, many banks need to make structural improvements to their business model – whether on the income side or the cost side – to generate adequate profits in line with their cost of equity and ensure their sustainability.

Supervisors will continue to closely monitor banks’ profitability drivers and accounting practices, as well as the sustainability of their business models. Each bank is different, and its supervision requires a thorough understanding of the unique aspects of its business model. Looking at aggregate developments can reveal common risks – and point to possible solutions. In a stable banking system, the banks with above-average profitability are those with good management, good governance and highly effective strategic steering capabilities that result in a sound business model.