The challenges and future of banking in the EU

Discussant Remarks by Pentti Hakkarainen, Member of the Supervisory Board of the ECB, at the ESRB Annual Conference, Frankfurt, 22 September 2017

I will present today on two topics.

As a starter, I will speak about the legacy issue of Non-Performing Loans, NPLs for short, that some banks are facing. I will provide some thoughts on why and how banks should progress further towards solutions in this area.

The main theme I will address is euro area bank profitability. Here I will briefly explain the current state of bank profitability in Europe. Looking forwards, I will move on to set out some opportunities I believe exist for banks to improve profitability in future.

NPLs adversely affect current business

The economic and financial crisis we have suffered in Europe since 2008 has resulted in high levels of NPLs. This problem is spread unevenly. The weighted average NPL ratio across Significant euro area banks is now below 6%, but in a few countries this number is above 40%, and in too many cases it remains above 10%.[1]

This diverse picture reflects that many euro area banks have successfully managed to avoid this problem. Their loans in the run up to the crisis must have been good, or alternatively they have managed to swiftly cleanse bad assets from their balance sheet.

In troubled economies the problems have been bigger. Nonetheless, even in those circumstances there are banks that have managed to avoid high levels of NPLs, or have managed to solve and reduce acute NPL problems.

Despite some recent progress in addressing the problem, it remains too big. The relative slow pace of progress may partially reflect the lower incentives that banks have to fix things whilst interest rates remain low. In such circumstances it remains possible to make various arrangements to keep bad assets on the balance sheet at relatively modest cost. It can therefore be attractive for banks to retain NPLs – rather than to face up to the hard task of shifting them.

The continued high NPL stock is a major economic concern.

On a macro level, a major NPL stock reduces the banking system’s capacity to finance the needs of the real economy – such as new entrepreneurial projects. When the asset side of bank balance sheets becomes stuck in unproductive NPLs, this limits the scope that banks have to finance new loans. Further, when NPLs are high – bank funding costs increase, and this translates to some extent into higher costs of borrowing for customers.

On a micro level, a large NPL problem is a drag on the profitability of individual banks – as banks are overly-invested in assets which are not generating any revenue. It can also mean that bank managers get distracted by the need to manage their problem assets. This takes away managerial attention from the core tasks of finding innovative ways to improve efficiency, and identifying productive new business lines.

Banks are responsible for fixing their own problems

Unfortunately there is no panacea available that will solve the current situation overnight. Indeed, as the ECB President yesterday stated, there should be adequate incentives and procedures provided by governments for banks to solve swiftly their NPL problems.

Research, and also our practical experience to date in addressing NPLs during the crisis, indicate that a proactive approach pays off. Regarding the allocation of roles in the task of reducing NPLs, it is relevant to ask – “what is the root of the current situation?”

On this topic, some might claim that the majority of NPLs generated in crisis countries were “unavoidable”. In this regard, I have seen some interesting recent empirical research which analyses the determinants of high NPLs in certain struggling euro area banks. This suggests that the biggest problem has been the macroeconomic slowdown, rather than – for example – an irresponsible credit boom.

From this perspective, one might say that it was not the banks’ fault – and therefore that public policy should step forward to take the lead in finding solutions. Personally, this is not my reading of things – even if the problem has been driven by an “exogenous” macroeconomic shock.

We do not want a situation where bank losses generated during macroeconomic downturns are socialised as a matter of course. Good bank business models must be resilient to macroeconomic shocks. Banks therefore require a cautious approach which builds in the capacity to cope with major macroeconomic downturns.

Such prudent management implies limiting risk appetite ex ante. Specifically, this will involve due consideration of – hedging, risk buffers, capital cushions, and limitations to credit risk in the good times. Where banks have not done this, and where they therefore face big ex post challenges – they should face the consequences of their choices, otherwise long-term incentive problems will arise.

Banks should therefore recognise that they are the primary owners of any asset quality and NPL problems that may have arisen. In particular, banks should not sit on their hands in anticipation of a big public sector solution that will save them from the pain of cleaning up balance sheets on their own. Banks must act swiftly now to take all the relevant steps at their disposal to address this issue.

This said, I also acknowledge that in some cases it is understandable and even desirable to use an element of public support within the set of solutions. There are several initiatives to solve the problem with public money, and as time is of the essence, swift solutions like national Asset Management Companies could be well justified.

Since the next panel is focusing on detailed discussion of these proposals, I will not go into this territory today. Instead, let me turn to my next topic – on the prospects for sustainable bank profitability.

Profitability and business model sustainability

This is closely related to NPLs, as banks with large long-term NPL problems inevitably end up facing doubts about the sustainability of their business models.

Indeed, it is important to begin by acknowledging that there are circumstances when struggling banks do not have a realistic path out of the problems they face. In such cases, market forces must be allowed to do their job in pushing these unviable entities out of the market place. In the first instance this will mean private sector solutions, such as mergers and other forms of reorganisation. If this doesn’t work, the authorities may need to become involved, for instance via the use of resolution tools. Of course, bank business model viability isn’t only about NPLs. In addition to avoiding asset quality problems, banks also need to find ways to sustainably generate revenue, to keep costs down and thereby to make profit.

Recently, I recognise that the broad environment for bank profitability in the euro area has been challenging. Normal retail banking models rely on a healthy Net Interest Margin. However, Net Interest Margins are on aggregate currently low – and this has put the profits of banks with traditional models under pressure.

In this environment, banks have on aggregate generated return on equity of 4.4% in 2015 for significant euro area institutions, and again only 3.2% in 2016. However, this gloomy aggregate picture masks disparities and many institutions, across business models and across countries, manage to consistently outperform and generate much higher return on equity.

The forecasts of significant euro area banks indicate some optimism that things will soon improve – at least to some extent. On aggregate, forecasts show that these institutions aim for return on equity to increase on aggregate to 7.4% by 2019. This reflects their judgement on an increasingly positive macroeconomic outlook, which will reduce impairments, and allow profitable loan growth. Banks also tend to see opportunities to grow their income from fees and commissions – which they expect to rise by 15% by 2019.

Anticipation of a modest improvement can be justified. Nonetheless, bank profitability will remain a continuing challenge – and the SSM will therefore continue to keep a close eye on bank profitability and business models. However, as I said in a recent speech in Dublin[2], we supervisors are not in the business of micromanaging banks’ commercial strategies. It is good to allow room for banks to innovate, and to let markets function in rewarding the innovations that customers like. Our role as supervisor is to scrutinise banks’ plans to ensure these are realistic, and that these are consistent with the maintenance of a sound prudential environment.

Having said this, I would take the opportunity to note some short thoughts on how banks can support their chances to achieve sustainable profitability. One way to think about this is to consider the experience of Nordic banks – who are currently at the top of the charts when it comes to return on equity and cost-efficiency metrics. How did those banks get to that position, and what can others learn from this?

I can tell you that this was not an easy road, in fact it was a case of “survival of the fittest”. Following the Scandinavian financial crisis of the early 1990s, banks were forced to make massive changes to their business models. It was a period of consolidation with a lot of merger and acquisition activity. Some banks disappeared from the market, including some big systemically important institutions. Staffing levels were cut in half over a 5 year period, and the number of branches was reduced dramatically.

The banks had in earlier decades invested heavily in technology. But it was the crisis that forced them to reap the full available efficiencies that could be reached from this investment. This allowed them to be among the first to provide the full range of online banking services.

This experience teaches us that the banks who will prosper through and after this current period of industry flux are the ones who act quickly to adapt to new market realities. That means the ones who act early to achieve cost efficiency and technological proficiency will be the ones who succeed. Indeed, this is again what we are already seeing right now – the top performing banks in terms of profitability are the ones who are moving early on costs and technology. Banks who don’t act fast to keep up in these areas will inevitably end up falling behind.

Given this urgency, it is important that banks are benchmarking their progress in achieving efficiency against their peers appropriately. One practical and widely used metric for banks to use for this is the cost-income–ratio. It works well to reveal cost efficiency problems, and can thereby be particularly helpful to encourage of cost cutting. Indeed, I have heard some voices in the market speaking in favour of a 50% cost-income-ratio as an indicator of banks’ success or failure in achieving efficiency.

Such ambitious talk is laudable. However, there are three quite fundamental flaws to be taken into account with the cost-income-ratio, and these should be kept in mind. First, it doesn’t take any account of the risks that businesses are taking. Second, it may treat incorrectly costs that are incurred for the sake of achieving longer term benefits, such as – research and development, increased marketing efforts and other “investments in the future”. Finally, it does not take into account how revenues are generated, or how they can be generated in future. Given these issues, a range of metrics are required – including some which captures revenue-generation aspects. For example, “core banking income”[3], and “net interest income”[4] should also be considered.

Overall, considering the challenge banks face today in comparison to the challenges Scandinavian banks faced in the 1990s – there remains scope for today’s bankers to be optimistic. For example, reducing fixed costs was a much harder job back at the time when Nordic banks were shifting their business models in the 1990s. Even 10 years ago the challenge involved for a bank to digitise their services required that they build their own free-standing internal IT system.

Nowadays, the passage to a more digitised banking platform offers much wider opportunities for banks to cut down on fixed costs. Intelligent use of external providers of digital infrastructure allows banks to contract IT services in a way that is linked to customer volumes. IT cloud usage will take the costs further down. All this provides flexibility for smaller banks to potentially compete with bigger banks on a more equal footing – as huge fixed IT infrastructure costs are no longer creating such big barriers to entry.

The successful banks of the future will be the ones that exploit these opportunities and provide the value-adding innovations that customers want. Such innovation will need to reflect the recent changes in customer behaviour. “Digital Natives” don’t understand the concept of limited bank branch opening hours. They require access to all services 24-7-365.


To conclude, I want to emphasise that banks must be bold and dynamic in addressing the challenges they are currently facing.

Regarding NPLs, there is no merit for banks with problems in this area to play a “wait and see” game in the hope that either the macro-economy or fiscal authorities will provide a solution. Primary responsibility for solving such problems should always lie with the banks.

We all hope that macroeconomic recovery will make life easier in this and other respects. However, the low profits we have observed in the last 2-3 years are not merely a cyclical problem. Structural issues also exist, and in some cases these will require that banks find fundamentally different ways of doing business in future. Banks must also take care of cost efficiency, but not at the cost of innovations or other investment in the future.

Good bankers are not the ones who are comfortable to stand still. I am confident that our current generation of bankers will find the energy to succeed in the search for profitable ways to meet the changing needs of customers, and I wish them luck in this venture.

[2] Enhancing the environment for banking competition, Keynote address at the FIBI International Banking Conference 2017, Dublin, 22 June 2017

[3] Net interest, commission, and fee income.

[4] Net interest income (NII) is the difference between revenues generated by interest-bearing assets and the cost of servicing (interest-burdened) liabilities. For banks, the assets typically include commercial and personal loans, mortgages, construction loans and investment securities.

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