Challenges for (European) banks

Dr Andreas Dombret Member of the Executive Board of the Deutsche Bundesbank spoke on “Banks Navigating Uncharted Waters.” Non performing loans double what they were in 2009, Brexit, Basel, digital disruption and low interest rates are all creating uncertainty.

dbund-pic

Let me start with the pending divorce of the UK and the EU. I have mentioned it because of its political impact. But as you know, it has strong implications for the financial sector as well and will continue to do so. Many eyes are on the question of whether, and in what form, the UK will retain access to the single market. In the financial realm, the related question is whether financial firms in the UK will continue to benefit from what we call “passporting”. Currently, many international banks use London as a hub to conduct business within the European Economic Area. But depending on the deal that will be struck between the UK and the EU, passporting in its current form might end – and with it the possibility to enter the European market through the UK. Another open question is whether the City of London will still be in a position to clear euro-denominated swaps and other euro-denominated transactions once the UK has formally exited the EU.

These are just two of the most prominent examples of the regulatory uncertainty that is troubling the financial sector in the wake of the UK referendum. Further questions such as the free movement of labour, goods and services affect the UK economy as a whole and with it all the clients of banks.

Given that formal negotiations have not even started yet between the EU and the UK, there are still plenty of plausible scenarios for their future relations, and thus for the environment banks will have to operate in. This uncertainty surrounding Brexit will stay with the financial sector for some time to come, and there is no easy way around it.

Let’s move on to the second issue, which concerns regulation more generally. Earlier this week, I was in Santiago de Chile to meet with my colleagues from the Basel Committee, where we discussed details for completing Basel III. The rules based on this regulatory regime are currently being finalised and phased in. Important aspects of the current negotiations are the revisions made to the level and the calculation of capital requirements.

The need to adapt to, and comply with these new requirements is imposing costs on banks and causing headaches among bank managers. This holds for European financial institutions in particular. In comparison to Brazil, for example, the use of internal models for calculating risk-weighted assets and thus capital requirements is widespread in Europe. Consequently, any changes to this approach – as currently discussed – have much stronger implications for European banks than for their counterparts elsewhere.

It is therefore crucial that the final result of our current negotiations will be regionally balanced and does not undermine the risk-oriented approach of the Basel framework. The Committee was not able to reach such an agreement yet. We will continue our negotiations with the goal of ending regulatory uncertainty as soon as possible. And we will work towards finding a compromise before the Committee’s oversight body – the Group of Governors and Heads of Supervision – will meet in January.

In parallel with reforming Basel III, in Europe we have established the banking union with a whole new supervisory architecture at its core – the Single Supervisory Mechanism. This supervisory mechanism is still relatively new territory for banks, as it has just recently celebrated its second anniversary.

As you can see, the regulatory and supervisory world is changing significantly and rapidly for banks. Keeping up with these developments is a challenging task.

On top of that, we are currently seeing significant structural changes in the market environment for banks. Two developments are decisive here.

On the one hand, digitalisation is rapidly transforming the banking business. While technology has always played a prominent role in banking, the speed and force of the current wave of digitalisation is unprecedented for European banks. Small FinTech start-ups as well as major tech giants are forcing their way into the market, for example by providing instant payment services with a speed and convenience unmatched by the traditional services that banks have on offer. In parallel, technologies with the potential to disrupt individual business models are being honed and refined, and made ready for the market.

In contrast to some banks in Europe, most Brazilian banks are already well-advanced in digitalising their business. Ironically, this is due to the fact that they mostly set up their IT later than their European counterparts. This observation is very much at the heart of the challenge posed by digitalisation: in the field of IT and digital services, it is not sufficient to put up a high upfront investment in order to ensure quality that will last for years. Instead, you need to do both: move early on and then continuously keep up with the pace of digital innovation. Only then can you ensure both –  IT and cyber security as well as the quality necessary to satisfy an increasingly elusive customer base.

The impact of digitalisation on the financial world – and the world as a whole – cannot be overestimated. But there is a second structural challenge that is even more pressing for many financial institutions. I am, of course, talking about the prolonged period of very low interest rates.

The low-interest-rate environment is a prime candidate for the lure of the easy answer. And the seemingly easy answer is that low interest rates are the result of misguided monetary policy. But this answer reflects a common misperception as to the root causes of the low rates.

The downward trend in long-term nominal and real interest rates across the world has been visible since the 1990s. This trend accelerated after 2007 with the financial crisis. The macroeconomic literature currently discusses a number of structural causes as potential explanations. Without going into details on the research, there are indications that show that a slowdown in global growth together with shifts in savings and investment behaviour, partly driven by demographic change in industrial countries, have led to a fall in the price of capital. With the financial crisis and the recession that followed, the fall in the desired levels of investment together with expansionary monetary policy have pushed down rates even further.

In summary, not only are the very low interest rates influenced by central banks: they also reflect an economic malaise in the global and in the euro-area economies.

Irrespective of their origin, the very low interest rates pose a serious challenge for profitability in the financial sector. This is particularly the case for banks whose business model depends heavily on net interest income. First of all, the margins derived from maturity transformation are declining because of the very flat yield curve. And second, deposit-based refinancing which we have always regarded as highly desirable as a stable source of funding, even in crisis periods, becomes less attractive. This is because it is difficult to pass on negative rates to small private depositors in a very competitive market and when depositors always have the alternative of hording cash.

Despite the low rates, net interest income hasn’t been affected much so far. But the pressure on margins is going to mount over the medium term as outstanding loans are repaid and replaced by lower-yielding ones.

A major risk associated with a low-interest-rate environment materialises when that spell comes to an end. In this scenario, pre-tax net income would probably suffer a short-term slump, especially if interest rates were to climb abruptly following a long period of low rates. In the short term, this would lead to present-value losses. More importantly, as banks are by their very nature engaged in the business of maturity transformation, a rise in interest rates will force them to roll over their liabilities at higher interest rates. But the yields on their assets will still reflect the low-rate environment.

Moreover, the longer banks have to cope with low interest rates, the more they are likely to take risky assets onto their books. We can observe that banks are extending the average maturity on the asset side, which is exposing them to more credit default and market risk.

At the same time, European banks are still holding significant amounts of non-performing loans in their books. For the euro area as a whole, the stock of NPLs amounts to roughly 9% of euro-area GDP, more than double the level in 2009, and is only declining slowly. If we instead measure the amount of NPLs relative to total loans, we get the so-called NPL ratio. This ratio stands at 5.5% on average for European banks. However, we can see a strong dispersion of NPL ratios across countries. The highest NPL ratios are present in those member states that were hit hardest by the economic crisis that followed the financial crisis after 2007.

The high stock of NPLs ties up operational capacity of the affected banks, it involves legal as well as administrative costs, and it weighs on the capacity of those banks to extend new loans to realise profits and to support economic recovery.

Author: Martin North

Martin North is the Principal of Digital Finance Analytics

Leave a Reply