European banking industry faces another dip in economic profit

Economic profit remains difficult to generate in global banking. European banks continue to face pressure from low-interest rate margins, while operating costs and non-performing loans weigh heavily. In the US, improvements in operating costs were just not able to offset losses in trading and other income. Overall the industry has seen an eleven-basis-point increase in economic profit between 2012 and 2016.

The banking system was on the verge of collapse in the aftermath of the 2008 financial crisis – requiring considerable bailouts across various jurisdictions to stave off disaster. The industry faced considerable loss of face, as well as regulatory scrutiny. The years since the crisis have seen the industry begin to recover.

Although centred in the US, the crisis had major repercussions across the Atlantic in Europe, where banks came under severe scrutiny and restrictions, particularly with respect to capital buffers and risk mitigation. As a result, European banks were forced to restructure, cutting costs where they can, and struggling to meet the new regulations. 

Despite these challenging circumstances, banks in Europe have managed to achieve relatively steady growth over the last decade. A major factor responsible for this recovery has been the support provided to the banking sector from investors to manage the €1 trillion of non-performing loans that continue to plague the European market.

However, the sector appears to have hit another bump in the road, according to The Boston Consulting Group (BCG), one of the world’s largest strategy consulting firms. The firm recently released a report into the current conditions in the industry, titled ‘Future-Proofing the Bank Risk Agenda’, which suggests that the profits of the banking sector have weakened for the first time in half a decade. 

Banking on economic profit

The financial crisis was a monumental moment in history for banks that survived, many of which were nationalised, as bad debts brought them to their knees. As a consequence of the financial system’s irresponsible risk taking, regulators saw fit to implement a raft of new rules to limit the chances, and consequences, of a new crisis.

The implementation of the new rules, as well as wider litigation that followed from the crisis and subsequent scandals, has continued to affect the industry. BCG’s analysis shows that economic profit was hard hit – particularly in Europe and the US – in the years following the crisis. Very low interest rates, and fees pressures, have further hampered banks’ ability to generate net interest margins and, therefore, profits.

In Europe, for instance, economic profit generated, relative to their global average on a basis point basis, has remained in the negatives, ranging from -40 in 2012 to -26 in 2016. In the US, growth in EP’s positive climb out of the -11 basis points seen in 2012 declined in 2016, falling from 31 in 2015 to 27. The Asia Pacific also saw a decline between 2015 and 2016 – on the back of net interest income decline and increased risk and operating costs. Across all markets, economic profit fell by 5 basis points between 2015 and 2016, to 11.

European banks, particularly in Southern EU countries, remain blighted by non-performing loans. In Europe, the write off of many of the loans has been relatively slow, with average write offs relative to loan values as a % in the order of 1%. The US, meanwhile, sought to clear its non-performing loan portfolio more quickly, with write offs relative to loan volumes ranging from 5.2% in 2009 to a recent low of 0.8% in 2016. 

Closer look at economic profit

In terms of impact on economic profit for banks in Europe, weak fee income and low net income margins – as well as increasing operating costs – have impacted economic profit the most in 2016. The decline in net interest was the most impactful of changes for the period.

In the US, declines in trading and other sources of income offset improvements to operating costs for 2016, resulting in a small decline of 4 basis points. The Middle East and Africa was relatively stable in terms of operating cost in the most recent period, while net interest margins saw positive growth to see the region remain relatively stable to the year previous at around 50 basis points in the positive.