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Banks back to pre-pandemic profitability, but will it last?

16 November 2021

The coronavirus (COVID-19) crisis has been the third major cyclical downturn in the euro area economy after the 2008 financial crisis and the sovereign debt crisis. The first two episodes both left a mark on the profitability of banks under European banking supervision, not only at their peak but also in the aftermath. The sovereign debt crisis led to an increased non-performing loan (NPL) burden for banks, which weighed on their profitability for many years and proved very difficult to address.

With this in mind, the short-lived nature of the pandemic shock to banks’ profitability and, in particular, the speed at which banks returned to their pre-pandemic levels of profitability in the first half of 2021 have been somewhat surprising. The rebound in aggregate return on equity – a basic measure of profitability – to nearly 7% in the first half of 2021 came well ahead of banks’ projections from the beginning of the year. Back then, in an ECB survey on business plans, banks projected that they would achieve their pre-pandemic levels of profitability only in 2023. Now, recently published third quarter results suggest that profitability has stabilised at around the levels seen in the first half of the year.

To understand how banks achieved this rapid rebound in net profits, and to determine whether it is sustainable, it is important to look at how the pandemic has affected banks. Its initial impact was a spike in impairments on non-financial assets in the first half of 2020, driven by precautionary provisions for performing assets with a significant increase in risk. This took place in an environment characterised by unprecedented levels of uncertainty and, initially, a lack of insight about the potential duration and severity of the health crisis and the related restrictions.

The pandemic crisis did not lead to an immediate surge in NPLs in the banking sector, as the extraordinary public support measures aimed at companies and individuals together with state guarantees for loans and loan moratoria softened the blow of the economic downturn. Banks actually managed to further reduce their NPL burden despite the challenging environment, mainly through targeted NPL disposals as part of multi-year NPL reduction strategies. Net interest income came under further pressure as margins continued to decline, but its reduction was contained as banks maintained their lending to the economy.

More than one year on, the downside risks to economic growth have eased considerably owing to the success of the vaccine rollout and the gradual loosening of restrictions. NPLs have still not significantly increased and banks are no longer adding to the precautionary provisions booked last year. Impairment flows on aggregate have fallen by more than 60% year on year as at June 2021, returning to pre-crisis levels, and some banks have even partially reversed their precautionary provisions, reducing their impairment flows even further. This reduction in impairments was greater than banks had anticipated at the beginning of the year and it is the main driver of the recovery in net profits. On the income side, net fees and commissions have increased by more than 10% since the peak of the pandemic and trading revenues have recovered from a poor 2020, while net interest income is still slightly below pre-crisis levels. On the expenses side, banks are spending much more than during the worst of the economic downturn, but expenses remain below pre-crisis levels.

At first glance many things appear similar to the pre-crisis period: the aggregate return on equity is above 6%, and costs and impairment flows are at similar levels to those seen before the pandemic. But this does not properly reflect the effects of the ongoing transformation in the sector and the delayed impact of the pandemic. First, banks have generally managed to increase their fees, thus finding ways to offset the continued pressure on lending margins and making their business less dependent on interest income. This does continue to be the most important source of income though, accounting for almost 60% of significant banks’ aggregate income. Investment banking has been a major driver of higher non-interest income since the pandemic broke out and, in the specific segments of debt instruments and syndicated loans, the global market share of euro area banks has grown over the same period. Banks have increased their overall revenue while keeping costs stable, resulting in an improved cost-to-income ratio of 65.4% in the second quarter of 2021, down from 66.5% before the pandemic. Second, banks are increasingly passing negative interest rates on to their depositors in order to protect their margins in the low interest rate environment – this now affects more than 35% of corporate deposits and more than 5% of retail deposits. Third, customers are now more receptive to digital services, and banks have used this to their advantage by accelerating their digital transformation, at the expense of physical branch networks. These changes may help banks ensure the sustainability of their business models.

However, the full impact of the pandemic on the balance sheets of banks is still not fully known. Despite the decline in NPL ratios and the low insolvency levels in 2020 and 2021, close attention needs to be paid to asset quality as the government support measures are phased out. At the same time, certain economic sectors that were particularly vulnerable to the pandemic are still feeling its impact, while others are being hit by secondary effects such as supply chain disruptions. At present banks do not generally seem to be anticipating a significant deterioration in asset quality and, as previously mentioned, some banks have partially reversed their precautionary provisions. In many cases, borrowers’ capital and profitability have suffered during the pandemic and the liquidity they have built up via the support measures is keeping them afloat. But, in some cases, this may only delay insolvencies. The ECB has identified warning signs, such as an increase in the NPL ratio for loans under moratoria and public guarantee schemes – probably the most vulnerable assets on banks’ balance sheets – and a rise in forborne exposures. Inflows of loans into the underperforming category have slowed down in some vulnerable sectors but continue to increase in others, such as accommodation and the arts and entertainment sector. These developments could suggest a deterioration in asset quality.

Overall, banks’ pre-impairment profits significantly exceed impairments, which is the first buffer against capital losses. Negative developments can also be cushioned by comfortable capital levels, which is why ECB Banking Supervision called on banks to remain prudent and to not underestimate credit risk when they decide on dividends. So long as the ultimate effects of the pandemic on asset quality remain unclear, banks are not out of the woods, as the rapid rebound in profitability might be short-lived. The swift recovery was partly driven by volatile sources such as trading income, which could quickly drop to lower levels. And even if the situation is not aggravated by a pandemic-induced surge in NPLs, banks cannot afford to be complacent. The financial stability outlook points to growing signs of vulnerability, notably in the real estate sector, and leverage has continued to increase, despite the pandemic, in the risky segments of credit and equity markets. This leaves the banking sector exposed to sudden adjustments and a potentially bumpy exit from the crisis.

Banks’ profitability is still too low and warrants structural solutions. Despite the recent recovery, return on equity is below the estimated cost of equity for around 75% of banks. This has been the case for too long and needs to be tackled definitively. Banks can only sustainably increase their profitability if they optimise their business models and take decisive action towards enhanced cost efficiency. They should refocus on opportunities that create longer-term value and decrease excess capacities in the sector. ECB Banking Supervision will support this process and will encourage banks to address these structural issues, while keeping a close eye on their risk-taking in this uncertain business environment.


Banco Central Europeu

Direção-Geral de Comunicação

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