The European Banking Authority (EBA) has published its latest assessment of risks and vulnerabilities in the banking sector.
The main themes have changed little since previous such reports – low profitability, high levels of non-performing loans (NPLs), the low interest rate environment, weak asset growth, a steady strengthening of capital ratios, and some signs of difficulty in raising long-term debt.
The EBA report (PDF 1.60 MB) is based mostly on reporting data (as at end-June 2016) for 131 major EEA banks and a survey questionnaire for 38 EEA banks.
Profitability remains a major challenge. The RoE for the sample banks was 5.7 percent, down from 6.7 percent a year earlier, even with a reduction in impairment charges. As already covered in our own paper on the profitability of EU banks, the main problems for the banks are low levels of net interest income, stubbornly high cost to income ratios (the EBA reports an increase in this ratio to 63 percent, from 59 percent a year earlier), and significant litigation and conduct costs.
It is interesting how widespread these conduct costs are. 44 percent of the surveyed banks have made compensation, litigation and similar payments of more than € 500 million since 2007, and they do not expect compensation and redress payments to decline in the near term future.
Looking ahead, the surveyed banks intend to compensate for their lower net interest margins with other sources of income, mainly fees and commissions. However, as the EBA observes, this may be challenging for individual banks (not least because of the growth of FinTech and non-bank competitors) and is unlikely to be achievable for all banks simultaneously. Banks also have plans to reduce their operating expenses, through reductions in overhead and staff costs, increased automatization and digitalization, and cutting non-profitable units.
Although the ratio of NPLs to total loans has fallen slightly it remains above 5 percent for this sample of banks. And the average is above 10 percent in one-third of EU countries. The EBA does not seem optimistic that these ratios will be reduced quickly. It sees the need for supervisory actions to ensure correct identification and efficient management of NPLs and conservative provisioning policies; for structural reforms to improve loan recovery processes; and to develop an efficient secondary market in NPLs.
The EBA points to a modest increase in sample banks’ total assets and total loans since 2014. However, the increases have been small, and closer analysis of the figures shows that total loan growth is being driven by mortgage lending, while cash balances and derivatives are the main drivers of the increase in non-loan assets.
This shift towards lower risk weighted assets continued the downward trend in banks’ credit risk exposures, while there was also a further reduction in market risk exposures.
Overall for the sample banks, credit risk accounts for 81 percent of total risk exposures, operational risk 10 percent, and market risk only 6 percent.
Minimal balance sheet growth has enabled the sample banks to increase the proportion of their customer funding. But 2016 has not been such a good year for issuing longer-term debt instruments, in particular for banks perceived to be higher risk and for banks headquartered in countries with weaker macroeconomic fundamentals. Some banks may therefore need to issue further MREL eligible instruments to meet their eventual MREL requirements.