The future of European banking

Panel intervention by Pentti Hakkarainen, Member of the Supervisory Board of the ECB, to Panel 1 “The Future of European and Global Banking” at the 25th Dubrovnik Economic Conference, Dubrovnik, 15 June 2019

I am glad to have the chance to speak today, and to explore what may lie ahead for the European banking sector.

In addressing this topic, I will seek to answer three questions.

First, where is European banking today? I will touch upon the industry’s resilience and profitability, and recent structural changes.

Second, what is the role of public sector decision-makers in shaping what happens next? Interactions between the state and the banking sector are critical in shaping the industry. So it is crucial that the state approaches these interactions with a clear view on what its role is, and what it is not.

And third, how will private forces affect future banking structures? I will focus on new technological changes – and the associated changes in customer behaviour – and the impact they will have on the traditional assumptions that have underpinned our understanding of the banking sector.

Where are we now? The current state of play for the European banking sector

In the five years since the banking union was launched, there has been a marked improvement in the resilience of the banking sector.

Banks have strengthened their balance sheets, not only when looking at risk-based metrics but also in absolute terms. Their average Common Equity Tier 1 (CET1) ratio rose from 11.3% at the end of 2014 to 14.3% at the end of 2018, due to an increase in CET1 capital and a reduction in risk-weighted assets. Their average leverage ratio, which measures balance sheet strength without risk weight, improved from 4.0 % to 5.3% over the same period. Likewise, the level of non-performing loans (NPLs) on the balance sheets of banks under our supervision has fallen from €1 trillion in early 2015 to around €580 billion today.

However, despite this improved resilience, banking sector profitability has remained stubbornly low. At just over 6% in the fourth quarter of 2018, euro area banks’ return on equity (RoE) was around the same as in the previous year and this leaves it still just below the level required for profits to outweigh the cost of equity. As a result, most European banks are trading at price-to-book ratios that are lower than those of their international peers.

This is not to say that all euro area banks have an identical profitability outlook. A number of them are currently very profitable, including some with double-digit RoE in the most recent figures, and some have been performing strongly for a significant period of time. Aggregate numbers tend to hide these good results. Two common features of these successful banks are their high cost-efficiency and their intensive use of modern technology.

So why is the euro area banking sector as a whole struggling to improve profitability?

Whilst multiple factors play a role, I will today focus on the excess capacity of the euro area banking industry – as in my view this is of particular importance. Signs of this excess capacity are noticeable within the poor cost-efficiency performance of euro-area banks in comparison to their peers. This underperformance is observable in the generally excessive number of branches in relation to their customer base, and also in excessive staff costs.

As ever, one must be careful in generalising when speaking about euro area countries. There is a lot of dispersion across these countries both in terms of the density of branches, and in the way that this figure has changed. Five euro area countries[1] have only 20 bank branches per 100,000 inhabitants, whereas eight have over 40[2]. In countries such as the Netherlands, Finland, and Estonia branch density has dropped by 40% or more over the past decade. Conversely, in countries such as Germany, France, and Austria branch density has not moved nearly so dramatically.

It is not easy to definitively pin down what has led to this situation. One relevant factor is that the injections of public money to keep the banking system functioning during the crisis also kept some banks afloat that otherwise would have exited the market. And perhaps some banks are being kept up and running for reasons beyond the pursuit of commercial profit, for example for the sake of maintaining national champions as a matter of national interest.

Regardless of how much excess capacity there is, it seems fairly clear that European banking needs to enter a period of consolidation, with less profitable banks exiting the market or being taken over by their more profitable competitors.

It is likely that the current infrastructure of the European banking sector could serve the population of Europe many times over.

Let’s now look ahead at the forces that may influence the future of European banking.

Public sources of change – the role of public decision-makers in bank consolidation

I will begin by considering how the public sector can influence things.

States are keen to ensure that critical financial services are continually available at an affordable price to domestic individuals and businesses. These services can play an important role in helping facilitate members of society in their pursuit of the positive economic outcomes they desire. A well-functioning banking sector is therefore essential for a modern economy.

Given these interests, how – if at all – can the public sector play a useful role in shaping the industry?

The state’s most crucial contribution is to provide the conditions that allow the banking sector to sustainably deliver what firms and individuals need. This requires the banking sector not just to be safe and sound, but also competitive and innovative.

First and foremost, states need to have the right attitude towards the benefits of open and competitive banking markets. This requires them to recognise that the more advanced and efficient the financial sector is, the more it can contribute to the real economy. It can efficiently allocate resources, it can provide entrepreneurs with access to finance for new value-creating projects, and it can give savers a fair return on their investments.

Based on this understanding, the state is able to set appropriate and unbiased conditions within which the financial industry must operate. In doing so, it must ensure that competition in the market is orderly and fair, thereby allowing healthy incentives to emerge for banks to improve their productivity through positive innovation.

It is categorically not the role of states to rescue non-viable banks. Such entities must be allowed to exit the market, leaving space for more competitive banks to fill. For the benefits of competition to be achieved, market forces must be allowed to take full effect.

This is particularly true in the current environment. Governments should not be tempted to intervene in ways that will stop consolidation from taking its natural course. Bailing out failing institutions leads to wrong incentives, wasted taxpayer money and delays to necessary consolidation.

More broadly, we are fortunate in Europe to have the banking union in place. The Single Supervisory Mechanism provides sound supervision, ensuring that the single rulebook is adhered to. In addition, the Single Resolution Mechanism provides the basis for sound bank resolution. This means that failing banks are able to exit the market without causing major problems. The European deposit guarantee system will, eventually, complete the banking union and level the competitive playing field still further.

The banking union provides many of the conditions needed for the state to help foster a healthy banking sector. These conditions also make it easier for governments to make tough but necessary decisions when dealing with problematic or failing banks.

European banks have never had such a level playing field across Europe before. It creates an attractive opportunity for efficient banks to offer their services across countries and improve their profitability. Prudent cross-border expansion could be achieved, for example, through mergers and takeovers. Such consolidation would result in a financial industry that is better equipped to efficiently provide the services that customers demand.

It is time to take advantage of this new framework and allow market forces to exert their positive effects.

Private sources of change – the effect of new technology on structures and incentives

Of course, the future of the banking sector is not principally in the hands of the public sector. As private sector entities, banks need to take responsibility for their own actions in adapting and preparing for the future.

There is presently a gap in profitability between euro area banks and their international peers in similarly advanced economies. As I mentioned earlier, this profitability gap can be largely attributed to euro area banks’ low cost-efficiency. They need to adjust their business practices to address this problem.

The statistics show that various business models can lead to good profitability and that there is no one-size-fits-all strategy.

Nonetheless, two common features of well-performing and profitable banks are high cost-efficiency and intensive use of modern technology.

The use of modern technology in banking will inevitably accelerate further in the coming years. This is not only necessary for banks to operate efficiently; it is also demanded by customers. There will be winners and losers in this process of adjustment, and banks that invest in improving customer convenience will be the ones that thrive going forwards.

Given the changes in customer behaviour, physical access to retail banking facilities is likely to continue to lose importance over time.

Convenience will be the driving force, with customers becoming less interested in the name or geographical location of the underlying service provider. They will have access to a broader set of financial services provided from a wider range of locations.

New technology in the banking sector and the improved conditions for providing financial services across borders can strengthen financial stability – a significant benefit for society as a whole. Possible disruptions in the provision of banking services arising from a failure of local lenders can be mitigated by an increase in the availability of online banking services. As customers diversify in this new environment, it becomes easier to allow market forces to work and consolidation to take place.

Conclusion

While the transition to using ever more advanced technology will not be easy for everyone in the industry, efficient banks will thrive and the outlook for all customers – both firms and individuals – is positive.

The public sector must concentrate on its role of setting good rules and being a fair referee. Within the framework that is set out, market forces and vigorous competition should be allowed to flourish.

Banks are private sector firms in a competitive environment – they must take the bold steps necessary to achieve sustainable profitability.

Let me conclude on a positive note. Based on what I have said today, there is every reason to be optimistic that the banking industry in Europe will have a profitable and cost-efficient future.

[1]Estonia, Netherlands, Latvia, Lithuania and Finland. See ECB Financial Stability Review, May 2019 - https://www.ecb.europa.eu/pub/financial-stability/fsr/html/ecb.fsr201905~266e856634.en.html#toc27
[2]Germany, France, Luxembourg, Austria, Italy, Spain, Cyprus, and Portugal. See ECB Financial Stability Review, May 2019 - https://www.ecb.europa.eu/pub/financial-stability/fsr/html/ecb.fsr201905~266e856634.en.html#toc27

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