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The Jury Is Out: Will European Banks Fly Or Flounder As Competition Increases?


Default, Transition, and Recovery: Two Defaults Brings The Corporate Tally To 67


Credit FAQ: Why China Property Firms Are Succumbing To Evergrande Effects


Industry Report Card: Large U.S. Banks' Profitability Should Rise Despite Limited Reserve Releases


Sustainable Covered Bonds: A Primer

The Jury Is Out: Will European Banks Fly Or Flounder As Competition Increases?

Europe's banks held firm during the COVID-19 shock, in part due to their efforts to rebuild their balance sheets and to the significant enhancements in bank regulation since the global financial crisis. Yet strong bank balance sheets alone will not be enough to ensure that they not only survive but also thrive. Indeed, some banks argue too much regulation could handicap their competitiveness and sustainability. A recent S&P Global Ratings conference thrashed out these issues to determine what lies ahead.

"With European banks having regained their footing after a very tough decade, the question is where will they go from here?," said S&P Global Ratings credit analyst Osman Sattar. "Are they ready to fly, or will they flounder, as new opportunities and competitive challenges arise?".

We posed this "fly or flounder" question to the speakers and panelists at our European Financial Institutions Conference 2021 (see table 1 and link to replay here). Participants included top regulatory experts as well as industry representatives--whose views don't, famously, always align. S&P Global Ratings credit analysts also joined the discussions that ranged from profitability challenges, climate risks, and the potential development of central bank digital currencies (CBDC), which could cut out banks as financial intermediaries.

On Stage: Guest Speakers At The European Financial Institutions Conference 2021
Elizabeth McCaul Member, ECB Supervisory Board
Carolyn Rogers Secretary General, Basel Committee for Banking Supervision
Philippe Heim Chairman, La Banque Postale
Dr. Philippe Sandner Head, Frankfurt School Blockchain Center
Dr. Alex Wieandt Senior Advisor, Nonexecutive Board Member, and Finance Professor
Source: S&P Global Ratings.

Does The Horizon Include A Steeper Yield Curve?

Most participants doubt the sector's traditional bread-and-butter of lending margins will be enough to sustain it well into the future. The days of healthy net interest margins (NIMs) are unlikely to return anytime soon. Indeed, we expect the eurozone deposit rate will remain negative through to 2024.

Even recent inflation worries, arising from supply-chain disruptions and spikes in energy prices, have failed to steepen the yield curve by much.

"I see inflation as transitory," said Sylvain Broyer, Chief EMEA Economist at S&P Global Ratings--pointing to steady labor unit costs and predicting that oil would have to jump to US$120/barrel and stay there for inflation to remain as high next year as it is currently. Meanwhile, robust employment levels and a large pool of household savings are likely to continue boosting consumer spending and could set banks up to fly, at least during the post-COVID recovery.

However, while that cycle is improving, the sector's structural challenges remain, and may even deepen. Banks must be ready for the "next new normal," said Elizabeth McCaul of the European Central Bank's Supervisory Board.

Cross-Border Consolidation Is Tough Until Banking Union Progresses

Readying for an unknown future could involve bank consolidation to reduce excess capacity in Europe, the creation of new business lines to boost fees and commissions, as well as better risk management and stronger internal controls. "Don't just hastily lay off staff to boost cost efficiency," warned Ms. McCaul. "Invest in structural transformation for long-term value creation."

None of the solutions are easy and all will take time--and resources--to bear fruit. We polled the conference audience to gauge views about the profitability of European banks over the next five years, and found that around 45% felt that banks would be unable to consistently earn returns above their cost of equity within the next five years (see chart 1). Still, the majority felt that banks would reach this goal, either from cost efficiencies (28%), rises in NIM (19%), or because of bank consolidation (8%).

Chart 1


On the question of consolidation, Philippe Heim, chairman of La Banque Postale, pointed out that gaps in Europe's banking union stymie cross-border business models, particularly regarding the inability to freely circulate a banking group's capital and liquidity across EU borders. "If you can't repatriate deposits from another country in the EU, that's a problem," he said. At this stage, Mr. Heim sees room for cross-border consolidation only in "verticals; like in asset management or in payments."

European Banks Back On A Broadly Stable Ratings Outlook

Our projections envisage that the sector's average return on equity (ROE) will climb back around to 5%-6% in 2021, but then stall (at around 6%) in 2022. That is still typically below the cost of capital for most banks, said Giles Edwards of S&P Global Ratings. Nor have cost efficiencies for the sector materially improved. His conclusion? "Profitability will remain constrained," particularly if banks stick with current operating strategies. In addition to cost efficiencies, sustainable profitability will likely have to come from the revenue side as well, including new fees and commissions.

S&P Global Ratings has a broadly stable outlook on European banks, reflecting less uncertainty as Europe emerges from the pandemic, and the expected moderate deterioration in bank asset quality is likely to be manageable. European banks' improving resolvability aided by growing bail-in buffers offers greater protection to senior preferred creditors, and so provides further upside potential for ratings on some European banks.

While just over half of conference participants were cautiously optimistic about the future of incumbent European banks, more than a quarter believe they are on the road to a slow decline (see chart 2). That pessimism is likely associated with technological changes that threaten banks' core roles as the middlemen between savers and borrowers.

Chart 2


Et Tu, Central Banks?

The banking sector has already faced disruption from digitalization, and increasingly, from blockchain technology. Added to this is the fact that central banks would have the possibility to cut out commercial banks as intermediaries, if and when CBDCs are rolled out.

"If central banks open and manage all the CBDC accounts themselves then banks will lose their raison d'etre and at least some of their deposits," said Mohamed Damak, a credit analyst at S&P Global Ratings. "That would profoundly impact their intermediation function."

Dr. Damak still believes that Central Banks are leaning towards a model where banks will have a role to play. By embracing the blockchain technology and the concept of 'disrupt yourself or get disrupted,' banks could create new growth opportunities and reduce credit costs.

The greater risk is that Europe's policymakers and banks put their heads in the sand, refusing to acknowledge these realities. The audience shared this view. A solid third of polling respondents said European banks are less prepared for a crypto revolution than their Asian counterparts (see chart 3).

Chart 3


Europe appears also slightly behind the curve on tax and legal structures for blockchain. Several panelists pointed to an apparent lack of political will and leadership for this. Dr. Philipp Sandner, head of Frankfurt School Blockchain Center, predicts China will go live with its CBDC next year, giving the country a first-mover advantage in infrastructure that could eventually be globalized.

Dr. Sandner also thinks that banks in Europe are unprepared for the emergence of a new crypto or blockchain based infrastructure.

Yet optimism prevailed among the panelists. They agreed that with the right investments and planning, the threats posed by the technology could become opportunities for banks.

For example, while there has been much talk about crypto facilitating money laundering or other illicit activities, blockchain-based financial services could serve to tighten risk controls and transaction traceability.

Axel Wieandt, a finance professor, pointed to financial jitters caused earlier this year when Archegos Capital Management placed too many leveraged bets on asset-price movements. Banks that sold Archegos swaps failed to recognize the extent of the firm's leveraged bets. Is the solution a purpose-built blockchain that better tracks such exposures and allows for immediate action? "Perhaps a scandal like Archegos could have been prevented if the collateral was posted on the blockchain with an automatic smart contract liquidation protocol or immediate change in ownership," said Dr. Wieandt.

Investments in blockchain-based financial solutions could also help claw back some of the payments business that banks have lost to digital competitors. But if they don't, the risk is that they lose more payments business.

Is There 'Regulatory Gold-plating' That Handicaps European Banks?

Mr. Heim of La Banque Postale noted that banks in Europe play a larger role in lending to the real economy compared to U.S. banks. He noted that in Europe, banks supply about 70% of corporate funding, compared to just 20%-25% in the U.S.

"So, we need to reinforce the ability of banks to provide funding to our economy and our corporates," he said. In his view, this role could be hindered if regulations go too far or apply unevenly to banks, thus granting fintech competitors an advantage. The need for regulatory flexibility must figure in any debate on further Basel initiatives.

Keynote speakers Ms. McCaul, member of the ECB Supervisory Board, and Carolyn Rogers, Secretary General of the Basel Committee on Banking Supervision, both rejected assertions that prudential regulation was handicapping banks. Capital requirements applied equally across the board, they said, and had created a level playing field and improved resilience.

Ms. McCaul said it was "illusory" for banks to hope for a boost in return on equity through more lenient regulation and lower levels of Common Equity Tier 1. She said the supervisory community stood unified behind a full and timely implementation of Basel III and opposed a looser or delayed application of standards. And banks must engage in "bolder, more forward-looking, more structural changes" for the sector to thrive.

Ms. McCaul sees no rationale for opposing the implementation of Basel reforms in the short term. Indeed, in her view, a key reason why banks withstood the pandemic is because of the long-term and internationally agreed upon reforms enacted over the past decade.

Citing a European Banking Authority study, she said most banks are already meeting the likely end-point Basel III requirements today and will be able to maintain lending, even despite COVID-related losses. Secondly, the European banking sector is broadly indicating positive trends in its forward guidance, and is restarting dividend distributions. And third, an ECB study calculated that the costs of Basel III reforms in terms of potential GDP growth losses are outweighed by long-term resiliency gains.

Ms. Rogers pointed out that the past year had been a lesson in resilience and that banks had fared well considering the twin-hit of a global pandemic and subsequent shutdown.

"Banks went into this crisis well capitalized, less levered and with improved governance and risk management. So, they were able to play an important role within an important time in their economies," said Ms. Rogers.

Ms. Rogers cast doubt on the notion that regulators should lay off banks because COVID-19 had been tough on profitability. She said that some of the arguments used in "frenzied lobbying attempts" to water down Basel III were "weak and disingenuous." In particular, she noted that banks' resilience in last year's stress test was boosted by fiscal support and "tons of liquidity pumped into the sector by central banks."

Is Climate Risk-Weighting Next?

Environmental considerations are not, at present, material to bank ratings, explained S&P Global Ratings' Emmanuel Volland. Over time, however, they will likely be of increasing importance.

Climate could become more material if regulations evolve to require, for example, higher risk weights related to 'brown' exposures. Mr. Volland said that such weights might not be necessary in the short term, given that bank stress tests are sufficient tools to improve governance and risk management without the need for another set of capital charges. They are more likely to occur in the longer term.

"For now, the approach of regulators is more to put pressure on banks' management to proactively tackle climate risk and integrate them in their strategy and risk-management systems," said Mr. Volland.

Bear in mind that climate might not just be a cost as this area may also offer opportunities for European banks through either direct lending or market activities. The development of green bonds is a good example.

Chart 4


One thing is clear, though: bank disclosures on climate risk need to improve, to allow investors to better understand a bank's relative risks in this increasingly important area. More than 70% of respondents felt that disclosures either did not provide enough information on climate risk, or were simply not good enough (see chart 4).

Not Flying, Not Floundering--A Longer Glide Path To Sustainable Profitability Is A More Likely Outcome

In wrapping up the session, S&P Global Ratings' Guy Deslondes confessed that the "fly or flounder" question is hard to answer. Uncertainty hangs over many fundamental issues.

Certainly, banks are in much sturdier shape than anyone expected one year ago. At that time there was no vaccine and little visibility on bank asset quality. Now, close to 70% of Europe's adult population is vaccinated, and 80% in some countries. Europe's economic momentum looks strong, driven by consumer demand even for higher-margin products and services, and job creation is expanding. The inflation risk looks mostly temporary, much due to bottlenecks. And the current price dynamics aren't all bad for banks.

On the other hand, banks' investment needs are high, given competitive challenges (though also opportunities) from digitalization, crypto, and CBDC. Meanwhile, regulatory requirements are set to deepen, and may evolve to be a greater cost for European banks compared to global peers. Clearly, longer-term clouds hang over banks' basic business models.

Mr. Deslondes noted that slightly more than half the audience is cautiously optimistic on the European banking sector (see chart 2)--and puts himself in the same camp. He notes how well banks and regulators worked together during the pandemic to deliver social and economic goods. This alone is a rationale to be positive to future regulatory changes that could help banks. For example, completing the banking union, thus making consolidation easier. Or setting more incentives for asset-backed securitization, as a route to relieve capital pressure on banks.

Finally, the technological challenges may turn out to be opportunities.

Writers: Cathy Holcombe and Lex Hall

Related Research

  • The Resolution Story For Europe's Banks: More Resolvability, Consistency, Credibility, Oct. 5, 2021
  • Credit Conditions Europe Q4 2021: Rampant Recovery, New Risks, Sept. 28, 2021
  • Economic Outlook Europe Q4 2021: A Faster-Than-Expected Liftoff, Sept. 23, 2021
  • Digitalization Of Markets: Framing The Emerging Ecosystem, Sept. 16, 2021
  • To Mitigate Greenwashing Concerns, Transparency And Consistency Are Key, Aug. 23 2021
  • 2021 EU Bank Stress Test: More Demanding, Better Resilience, Aug. 2 2021
  • U.K. Banks' Earnings Rebound On Provision Releases, Aug. 10, 2021
  • Climate Risk Vulnerability: Europe's Regulators Turn Up The Heat On Financial Institutions, Aug. 2, 2021
  • A Little More Clarity, A Little Less Gloom: An Update On Our Bank Credit Loss Forecasts, July 15 2021
  • EMEA Financial Institutions Monitor 3Q2021: Resilience Amid The Search For Stronger Profitability, July 15 2021
  • As Near-Term Risks Ease, The Relentless Profitability Battle Lingers For European Banks, June 24, 2021
  • The Basel Capital Compromise For Banks: Better Buffers, Elusive Comparability, June 3, 2021
  • Economic Research: How The Capital Markets Union Can Help Europe Avoid A Liquidity Trap, April 15, 2021

This report does not constitute a rating action.

Primary Credit Analysts:Osman Sattar, FCA, London + 44 20 7176 7198;
Elena Iparraguirre, Madrid + 34 91 389 6963;
Alexandre Birry, London + 44 20 7176 7108;
Emmanuel F Volland, Paris + 33 14 420 6696;
Giles Edwards, London + 44 20 7176 7014;
Mohamed Damak, Dubai + 97143727153;
Markus W Schmaus, Frankfurt + 49 693 399 9155;
Guy Deslondes, Madrid + 34914233179;
EMEA Chief Economist:Sylvain Broyer, Frankfurt + 49 693 399 9156;

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