Profitability: banks expect to remain under pressure

When analysing the sustainability of banks’ business models, it is important to look closely at past developments in their profitability. However, it is even more important to understand how banks intend to develop their business models in the light of the challenges and opportunities ahead. Each year ECB Banking Supervision collects data on significant banks’ detailed projections of their profitability and balance sheets in order to monitor how their business models change over time.

Based on the banks’ latest projections, it seems that they may need to step up their efforts to ensure that their business models remain sustainable, for four main reasons.

First, banks themselves expect, on average, a dip in profitability (when measured as return on equity) in 2019, following the subdued levels of 2018, and only expect a rebound in 2021. The good part of the story is that banks continue to increase their equity, which improves their resilience to shocks. However, this also dilutes their earnings per euro of equity, weighing on their return on equity. Increases in net earnings are only expected to outpace the growth in equity in the years after 2019. In particular, net interest income – banks’ most important source of income – is projected to stagnate in 2019 and is only expected to increase over the following two years.

On aggregate, banks project that provisions and loan write-offs will increase slightly in the coming years, particularly in countries that currently have low levels of non-performing assets. This indicates that banks think 2018 may have marked a turning point for credit quality in these countries.

All this means that, even at the end of the three-year forecast horizon, about half of the banks still expect to generate a return on equity below their own estimates of their cost of equity – and the low valuation of listed banks is evidence of this problem. Two-thirds of significant banks are not listed and might have more patient stakeholders, but this does not mitigate the issue in the long term.

Second, materialising economic challenges are already casting doubt on the feasibility of the projections, as the recent darkening of the macroeconomic picture makes the banks’ underlying assumptions look rather optimistic. The impact of geopolitical headwinds, such as trade disputes, and the uncertainty surrounding Brexit have left their mark on macroeconomic forecasts, which have been revised downwards significantly for the euro area. Lower economic growth can translate into lower loan growth and the need for higher provisions against losses on the loan portfolio, accelerating the projected increase in impairments. At the same time, banks see lower than expected interest rates exerting further pressure on their lending margins. At the beginning of 2019 banks cited low interest rates and macroeconomic uncertainty as the most significant risks to their forecasts. As these risks now appear to be materialising, banks should reflect this in the next update of their budgets.

Third, some banks underestimate the effects of competition. This is often the case with significant institutions’ business plans: the reactions of their competitors to their initiatives to gain market shares are not fully incorporated. Intensifying competition can be a major obstacle, in particular to ambitious plans to expand fee income from asset management and the distribution of insurance products in certain jurisdictions.

Last, banks plan to improve their operating efficiency not only by expanding income but also by reducing costs, as they continue moving towards a more digitalised world with leaner branch networks. Around 10% of significant banks are engaging in dedicated cost-cutting, with a view to reducing their costs by 15% or more over the next three years. However, experience from previous cost-cutting initiatives shows that there are execution risks and potential up-front increases in costs before these efforts start producing results, and income might also be affected.

It is first and foremost for banks’ management to weather the anticipated headwinds on profitability, without shying away from painful cost-cutting, and to redirect new business towards profitable activities. To this end, sound strategic steering, transparent cost allocation and rigorous loan-pricing frameworks are key.

And what is the role of banking supervisors with regard to banks’ business models? The assessment of business model viability and sustainability is a key element of the Supervisory Review and Evaluation Process. Supervisors provide banks with individual feedback on their business plans and the underlying assumptions. As for banks’ profitability outlook, supervisors focus on two aspects: (i) assessing whether banks’ business models are sustainable and not driven by undue risk-taking, and (ii) ensuring that banks’ business plans are realistic, and that banks anticipate challenges and can adjust accordingly. Back-testing of banks’ forecasts from previous years suggests that business plans for the near future tend to be relatively achievable, so long as no downside risks materialise, but that longer-term projections are tainted by some wishful thinking.