How to fix Europe’s lenders
IT’S NOT all bad. In 2008 Lloyds, a large British bank, took over HBOS, a rival that was being sucked beneath the rising waters of the global financial crisis. HBOS nearly dragged Lloyds under with it; £20.3bn (then about $ 30bn) of public money was needed to keep the combined group afloat. But these days Lloyds is doing all right.
Under António Horta-Osório, its chief executive since 2011, Lloyds has ditched almost all its foreign operations, narrowed its product range and (like many other banks) poured money into digitisation. The state sold its last shares in 2017. Last year the bank’s return on tangible equity (ROTE), a measure of profitability, was a decent 11.7%. This year Mr Horta-Osório is aiming for 14-15%, Brexit notwithstanding.
Some other European banks also have good stories to tell. The Netherlands’ ING is also a refurbished state-aid case. Its online German bank, ING-DiBa, claims to return over 20%. Spain’s Santander, the euro area’s biggest bank by market capitalisation, sailed through its homeland’s financial storm without a single loss-making quarter. On April 3rd it set out plans to lift its ROTE from 11.7% last year to 13-15% by cutting costs and exploiting digitisation. Nordic banks make bonny returns—although both Danske Bank and Swedbank, beset by money-laundering scandals, have sacked their chief executives recently.
But the overall picture is glum. In a quarterly survey published on March 29th, the European Banking Authority (EBA), a supervisor, found that in the last three months of 2018 the weighted average return on equity (ROE) of 190 European Union banks was 6.5%. (ROE is a little lower than ROTE because goodwill and other intangible assets are deducted from the denominator of the latter.) Over the past four years the average ROE in the EBA’s report has fluctuated between 3.3% and 7.3% (see chart).
That is not enough to keep shareholders happy. They want 10% or so. At a recent conference hosted by Morgan Stanley, 70% of attendees estimated European banks’ cost of equity (COE)—the minimum ROE shareholders consider acceptable—to be between 9% and 11%. Twice a year the EBA also asks banks to estimate their COEs. Last December two-thirds put their benchmarks at 8-10% and another one-sixth said 10-12%. Only 55% said that they were earning more than their COE.
That 6.5% is also well below the returns enjoyed by investors on the other side of the Atlantic. Among America’s biggest banks, only Citigroup reported an ROE of below 10% last year, and, at 9.4%, not by much. US Bancorp, the seventh-biggest by assets, weighed in with 15.4%. The Europeans underperform on whatever measure you care to choose—for example, ROTE or return on assets (ROA), which strips out the effect of gearing (the share of assets funded by equity). Figures supplied by Stuart Graham of Autonomous Research indicate that the average ROA of nine big American banks was double that of 24 leading European lenders.
All this is reflected in stockmarkets’ assessment of the relative worth of European banks. Markets value most big American banks at more than the net book value of their equity; but the shares of most leading European lenders trade below that mark. The price-to-book ratio of Deutsche Bank, Germany’s largest bank, which squeaked into profit in 2018 (with an ROE of 0.4%) after three years of losses, languishes at a feeble 25%. Deutsche is in merger talks with its neighbour, Commerzbank, which is rated little better, with a ratio of 31%. Unicredit, Italy’s biggest bank, is rumoured to be considering a bid for Commerzbank if the talks with Deutsche stall.
Explanations for European banks’ poor performance start with the aftermath of the financial crisis of 2007-08. American banks were swiftly and forcibly recapitalised through the Troubled Asset Relief Programme, whether they needed it or not (“They got TARPed,” in the words of one European banker). Most European countries (though not Britain, the Netherlands and Switzerland) were slow to act. The euro area lacked a single supervisor and a common authority for resolving failed banks. Both were established several years later—and only after the euro area’s sovereign-debt crises had compounded the troubles of many lenders.
Banks complain that policymakers have since made their lives hard. In the euro area net interest income, which makes up the bulk of banks’ revenues, has been ground down by slow growth and years of ultra-low, even negative, interest rates—banks must pay the European Central Bank (ECB) 0.4% a year to deposit money. In the past three years, reports the EBA, net interest margins have fallen from 1.57% to 1.47%. Mario Draghi, the president of the ECB, said on March 27th that “low bank profitability is not an inevitable consequence of negative rates”, although he admitted that the central bank would consider “mitigating the side-effects”. In March the ECB announced further operations to provide banks with cheap long-term finance.
Bankers also complain about capital requirements. Not only have these been tightened since the financial crisis, but the new rules, known as Basel 3, were finalised only at the end of 2017. Banks are having to raise billions in debt that would be able to absorb losses, should some catastrophe wipe out their equity. Magdalena Stoklosa of Morgan Stanley says that resolution regulation is obliging banks to finance themselves by fairly expensive means when deposits cost them nothing and margins are wafer-thin.
European banks also lack the scale of America’s biggest. Differences among national markets and the EU’s failure to complete its “banking union” thwart cross-border mergers that might create continent-spanning giants. Peer more closely at specific countries, and further burdens on profitability become visible. Banks in Cyprus, Greece, Italy and Portugal are still weighed down by bad loans, even if the load is getting lighter. Overcrowding is common; so is competition from publicly owned and co-operative banks, which have other goals besides profit. Germany is the harshest environment on both counts. Even combined, Deutsche and Commerzbank would struggle for elbow room.
But struggling banks cannot simply blame history, officialdom and market structure for their troubles. They could do a lot more to help themselves. The EBA’s new survey finds, for instance, that at almost three-quarters of European banks, costs consume more than 60% of income. The average cost-income ratio, 64.6%, is higher than it was four years ago.
Europe’s most successful banks show what can be done. A study by five ECB economists published last November—and commended to banks by Mr Draghi—found that euro-zone banks which have cut costs, spent heavily on information technology, are geographically diverse (like ING, Santander and BBVA, another Spanish bank) and rely less on interest income tend to be more profitable. Banks that carry lower credit risks (ie, that are safer) also do better.
None of this will transform European banking into a magic money tree. Banking everywhere is less lucrative than it was before the crisis. Banks can take some comfort from evidence in the ECB economists’ study and the EBA’s survey that COEs are coming down, largely as a by-product of persistently low official rates. But bank bosses would be foolish to rely on that—or to suppose that they are not ultimately responsible for their own fates.
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