Jan Schildbach, Head of the Banking, Financial Markets and Regulation team at Deutsche Bank Research (photo DB Research)
Obserwator Finansowy: What is the biggest weakness of European banks: bad assets, lack of capital or low efficiency?
Jan Schildbach: – The single biggest weakness of European banks at the moment is probably a lack of profitability, due to several reasons: revenues have slumped compared with pre-crisis times; they are currently about 20 pct. lower than in 2007. At the same time, operating costs have continued to rise, and when banks belatedly addressed this problem, other costs eliminated any bottom-line progress: charges from litigation, increased regulatory and compliance costs, plus a growing need to spend on technology to fight off new competitors. Many banks have not yet found a new balance that allows them to stomach especially some of the “non-recurring” or non-operating expenses without erasing much of the net income.
Are they able to face this problem?
Thus, in the medium term, either sector revenues will have to rise meaningfully or costs will have to be cut further for efficiency ratios to reach acceptable levels again. In other areas banks’ achievements are impressive – core capital ratios have roughly doubled since 2008, and are still increasing. Capital is not the prime problem any more. In terms of asset quality, there also seems to be light at the end of the tunnel – having remained elevated ever since the financial crisis of 2007-09, loan loss provisions of EU banks finally fell by a quarter year on year last year and continued along this path in the first half of 2014.
Do you see already some new prospects for growth and expansion for the banks in Europe?
Overall growth prospects for the industry may be relatively limited in the medium term. The adjustment towards a sustainably profitable, new business model is probably not over yet and as long as banks struggle to offer a convincing case for investors they will find it hard to attract fresh capital from the outside which in turn is needed to grow – given the meagre level of current retained earnings. Hence, a lot depends on the successful execution of banks’ announced cost saving measures.
Banks across the Europe have closed a number of branches, and laid off thousands of employees. That’s not enough?
So far, respective achievements have been too modest to compensate for the substantial hit to revenues from a weaker macroeconomy, significantly tighter regulation and the low interest rate environment. Nonetheless, there are a number of areas where banks can aim for considerable growth in the next few years: capital market operations linked to a growing demand for financing by corporates belong in that category, as do asset management activities – the global liquidity glut and extremely low yields have substantially raised the interest in qualified investment advice and good research. And, of course, new growth spots will emerge that we may not be aware of today – both due to new market and technological developments as well as innovation within the financial industry itself.
How is the banking landscape after the Asset Quality Review? Can we say that confidence has been restored?
The Comprehensive Assessment – mainly AQR and stress test – has been an important exercise and a precondition for the ECB taking over its supervisory tasks within the Single Supervisory Mechanism. They have enabled the ECB to get a profound view of the institutions it is now in charge of, based on a single set of rules and common assumptions. It has also helped creating more transparency over individual exposures for market participants and brought more confidence that capital levels at most banks are indeed sufficient to withstand even a serious downturn in both financial markets and the real economy. Thus, the Comprehensive Assessment has overall been a success.
Can we say that deleveraging is over?
It is not clear whether deleveraging and indeed shrinking of the EU banking industry is now over. Probably not yet in real terms, but we are seeing signs of a stabilisation in nominal figures. Total assets at euro-area banks are slightly up this year, having fallen by 13 pct. between early 2012 and end-2013. Lending to non-financial firms is still declining in terms of outstanding volumes, but at a slowing pace, and new credit flows have been steadily improving for several months. Therefore, it is quite likely that we will see a broad stagnation in lending – no further reduction but also no meaningful growth – for some years in many European countries. At the same time, the share of other providers of finance (capital markets, non-traditional lenders) may increase going forward.
Do European banks have the potential to finance the economy, or should companies look for financing from the capital market, similar to the situation in the US?
The share of (corporate) funding coming from the capital markets is probably going to rise further in Europe, following significant growth since the financial crisis, but from a rather low starting point. Due to the ongoing adjustment to the much tighter set of regulations, the banking sector as a whole may not be able to grow quickly enough in the next few years to provide all the additional funds necessary for new corporate investments. By contrast, there is ample demand for corporate paper from institutional investors eager to diversify their securities holdings beyond traditional government bonds. In the current rate environment, which is quite likely to stay with us for a prolonged period of time, this keeps market funding costs relatively low even for less creditworthy borrowers.
Are government guarantees for debt issuance by SMEs a new kind of risk?
In circumstances when some banks may be capital-constrained and thus unable to lend as much as their clients need, or when governments would like banks to finance companies they would normally not consider an attractive risk-return profile – such as many new, small firms without a credit history and sufficient track record – then there may be a case for public intervention. If most of the “excessive” risk from banks’ point of view is taken by a state-owned entity, this will not constitute a major risk for the lender. And given the overall rather moderate, limited amount of government guarantees provided in most European countries, it is hard to see the risk of a new, dangerous lending bubble stemming from these public interventions becoming really dominant in the foreseeable future.
What about the idea of a European union of capital markets as announced by the European Commission President, Jean-Claude Juncker?
There are a number of areas where the single market for financial services is not yet complete. For instance, securities trading is still largely nationally organised, which is partly due to numerous differences in the legal framework for the issuance of debt and equity, differing investor rights, insolvency and tax regulations. In addition, compared to the US, our venture capital segment is underdeveloped which hurts innovative, but cash-constrained young firms and impedes the process of “creative destruction”. Another weak spot is securitisation where much of the pre-2007 progress has been reversed since the financial crisis.
European Union capital markets should be our response?
Yet deeper, more diverse and better integrated capital markets in Europe are needed e.g. to i) help companies diversify their funding base beyond bank loans, ii) allow for better capital allocation and thus higher returns for savers (particularly relevant nowadays given the extremely low interest rates on deposits and life insurance policies) or iii) move public pension systems to an at least partly funded basis, instead of pure pay-as-you-go arrangements. And one of the best ways to strengthen European capital markets is to pull down the remaining barriers to a true single market for capital.
Interview by Jacek Ramotowski
Jan Schildbach is Head of the Banking, Financial Markets and Regulation team at Deutsche Bank Research in Frankfurt am Main. From 2007 to February 2014, he was Senior Economist covering European banking structures and trends as well as capital markets issues and regulatory developments. In addition, he did research on banking strategies and business models. He participated in the Retail Banking Congress held in Warsaw on November 12.