Challenging times for banking sector

The Vice-President of the European Central Bank, Luis de Guindos, very recently delivered a speech in London on the challenges for bank profitability across the eurozone. This speech is available on the website of the ECB and makes interesting reading. It is therefore worth highlighting some of the main findings that were presented.

Mr de Guindos argued that the recent softening of growth prospects across most economies led to heightened risks across the banking sector that have been evident for a while, namely “a possible disorderly increase in risk premia, debt sustainability concerns, low bank profitability and imbalances in the non-bank financial sector”.

The deteriorating macro-economic outlook may re-ignite concerns over debt sustainability and worsen the outlook for profitability across the banking sector. The Vice-President explained that “debt sustainability concerns could drive up sovereign bond spreads. In turn, higher spreads generate losses on bond portfolios and higher market-based funding costs for financial institutions”.

He also stated that “returning banks to sustainable rates of profitability is a key step towards ensuring that the sector remains resilient, particularly in the face of slowing economic momentum and the potential for market distress”.

Although banks across the eurozone have seen an improvement in profitability levels in recent years with Mr de Guindos stating that the average return on equity (ROE) was at circa 6% as at the end of 2018 (up from a mere 3% a few years earlier), the Vice-President indicated that this level of ROE for eurozone banks remains below the long-run cost of capital, which many banks estimate to be in the range of between 8% and 10%. In fact, he argued that this is the reason for the low valuation of eurozone banking equities with the price-to-book value multiples at well below one times.

Bank profitability is important for financial stability since retained earnings are an important source of capital, enabling banks to build strong buffers to absorb additional losses. Banks with a poor profitability level generally face higher funding costs. Such banks may also be tempted to take on additional risk according to a working paper published by the International Monetary Fund.

As was evident since the global financial crisis, the Vice-President stated that “dislocations in the banking sector can deepen recessions and seriously impair the smooth transmission of monetary policy across the euro area”. He also remarked that this risk is still very possible today.

The Vice-President of the ECB explained that European bank profitability has been structurally weak since before unconventional monetary policy measures were introduced (referring to the prevailing negative interest rate scenario and the various rounds of quantitative easing measures). Mr de Guindos cited three factors giving rise to weak profitability, namely cyclical factors, cost inefficiencies and competitive challenges arising from outside the banking sector.

In his speech, Mr de Guindos highlighted these factors in further detail. The Vice-President explained that while non-performing loan (NPL) ratios have improved in recent years helping the level of bank profitability to improve, overall revenue growth remains subdued across the European banking sector. As such, he argued that in order to improve the profitability levels of banks, it is vital for them to develop “sustainable revenue streams beyond net interest income, such as fee and commission income”. Mr de Guindos warned that “the low interest rate environment is with us for the foreseeable future and is caused in large part by durable structural factors”. Moreover, the Vice-President categorically stated that “even once monetary policy normalises, interest rates are likely to remain below levels that were common in previous decades”.

The second source of low profitability for euro area banks arises from cost inefficiencies with cost-to-income ratios in the euro area above those across other regions. In the speech, Mr de Guindos made reference to the aggregate cost-to-income ratio of euro area banks of 66% in 2018 up from 62% in 2010, as the decline in revenues was not offset by cost containment measures. Although this ratio is close to that of banks in the UK and Japan, the ECB Vice-President argued that the euro area level is above that for US banks and also for banks in the Nordic region which have a cost-to-income ratio of circa 50%. The Vice-President remarked that “the euro area has too many banks, too many branches and too many bankers”.

In order to address the high cost-to-income ratios, Mr de Guindos explained that banks need to grasp the opportunities offered by technology and, in this respect, made reference to the fact that the best performing euro area banks increased their IT spending by around 60% between 2009 and 2017.

The final challenge for bank profitability according to the Vice-President of the ECB arises from increasing competition from outside the sector, in particular from financial technology companies (fintechs) and other non-bank financial companies. He explained that “lightly regulated fintech companies have begun to encroach into payment and settlement systems” with more than 60% of banking incumbents viewing fintechs as a threat to their income from these activities. In this respect, the Vice-President also indicated that heavy investment in IT in this area is vital to secure future revenue streams “given the greater desire by consumers for instant payments and the use of mobile payments”.

Mr de Guindos also made reference to competition arising from capital markets in the provision of credit. Although he explained that the improved use of capital markets as an alternative method of funding is positive, there is also the “need to carefully consider how to adjust their [euro area banks] business models to accommodate this greater degree of competition and increases the urgency to improve efficiency in credit provision”.

In conclusion, Mr de Guindos re-iterated that “the structurally low profitability of the euro area banking sector remains a concern for financial stability and for monetary policy”. The Vice-President argued that consolidation across the sector is necessary since a “return on equity below the cost of capital is unsustainable in the long run”. Mr de Guindos stated that since the low profitability of the banking sector is mainly due to structural issues, “successful implementation of long-run profitable business plans is essential”.

In the light of the various challenges highlighted in this speech, it is worth reviewing the situation in Malta. The two largest banks recently issued their Interim Directors’ Statement in which they commented on the trends seen in the first quarter of 2019.

Bank of Valletta plc reported that profits in the first three months of the current financial year are lower than the corresponding period last year due to downward pressure on interest margins, higher costs and lower reversals of impairment provisions. BOV also made reference to the fact that it continues to implement its capital optimisation plan and is seeking to raise new capital to further strengthen its regulatory capital. In view of the repeated reference to the return on equity across the eurozone banking sector, it is worth mentioning that BOV’s ROE for 2018 was of 9.9% when excluding the €75 million litigation provision which hugely dented last year’s performance. Nonetheless, this was still lower than the annualised ROE of 11.3% in respect of the 2017 financial year which also comprised of a fifteen-month period.

HSBC Bank Malta plc recently reported that pre-tax profits during the first quarter of 2019 were in line with management expectations but lower than the corresponding period last year due to a higher level of expected credit loss releases registered in Q1 2018 compared to Q1 2019. The ROE of HSBC Malta was of 6.1% in 2018 compared to 6.5% in 2017.

On the other hand, the other retail-based banking institution listed on the MSE, Lombard Bank Malta plc, reported a ROE of 8.3% in 2018 compared to 5.4% in 2017 as it generated a substantial improvement in profits over the previous year to €8.5 million largely on account of a 13.5% growth in net interest income. Lombard has not issued any statement with respect to its performance in the first quarter of 2019, so the sustainability of last year’s record performance will need to be assessed once the interim financial statements are published in August.

Given the increased media coverage in recent weeks, it may also be worth mentioning the financial performance and ROE of another important local banking institution, APS Bank, although the bank’s shares are not listed on the MSE. APS reported that it generated €12.6 million in profits after tax during 2018 giving a ROE of 9.1% which is only slightly lower than the ROE of 9.9% recorded in the previous financial year.

Although the ROE’s of Malta’s banks are well within the upper range of the average of eurozone banks as indicated by the Vice-President of the ECB, many investors would have noticed that the ROE’s of local banks have decreased rapidly in recent years. On the other hand, companies in other sectors, including some of the newcomers to the Regulated Main Market of the MSE, are generating substantially higher ROE’s and clearly attracting a lot of investor attention. Over the years, many Maltese investors generally retained a heavy allocation of their equity component in their portfolios towards banks. The possible shift by investors into other equities generating more attractive returns could gather momentum given the challenging times for the banking sector. Hopefully, other investment opportunities in equities will soon be made available to the local investing community to assist them in repositioning their portfolios accordingly.

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