European banks run out of options to protect profits

When Commerzbank’s chief executive unveiled the lender’s new strategic plan last month, he kicked off the press conference by declaring “it’s a wonderful day”. Unfortunately for his investors, Martin Zielke was not referring to the prospects for Commerzbank, or the wider European banking industry: he was wishing his colleague a happy birthday.

It was a moment of levity in an otherwise grim presentation. Mr Zielke detailed a litany of woes that threaten the profitability of Europe’s banks, including prolonged negative interest rates in the eurozone, new regulations and sluggish economic growth.

Investors will hear the same refrain ad nauseam over the coming weeks as European banks unveil their third-quarter results. Some are better prepared than others to withstand the pressure, but all are facing the same reality: running a bank in Europe, already an uphill struggle since the crisis, is about to get even harder.

“Bank executives in Europe are depressed, despondent and concerned; there’s a confluence of factors that is undermining profitability in the medium term,” said one adviser to several large European lenders. “There are genuinely fundamental questions about their future.”

Chief among their woes is the spectre of persistently low interest rates in the eurozone. In September, Mario Draghi, the outgoing president of the European Central Bank, cut its key deposit rate to minus 0.5 per cent, putting further pressure on banks’ net interest income, the revenue they generate from lending. Markets expect rates to stay there or fall further after Christine Lagarde takes over.

The impact of negative rates is especially painful because many executives in Europe had hoped, until recently, that the ECB would start tightening monetary policy. One large banking investor describes their ill-fated approach as “the great reflation trade”.

Commerzbank’s new strategic plan shows just how damaging the ECB’s policy is for the region’s banks. In its previous plan, unveiled in 2016, the lender said that, if rates were to rise, it could hit a more than 8 per cent return on tangible equity — a key measure of profitability — by 2020. Fast-forward to the plan it announced last month, and the bank is now targeting a ROTE of “more than 4 per cent in the medium term”.

Negative rates are not the only factor threatening bank revenues. In Germany, Commerzbank’s home market, the industry is dominated by Sparkassen, lenders owned by local municipalities, and their larger siblings, the Landesbanks, which can offer uneconomically cheap loans because they do not have to worry about paying dividends or maximising profits. That forces Commerzbank and larger rival Deutsche Bank to write low-margin business to compete.

In the UK, banks do not have to contend with negative rates, even if they are close to historic lows. But recently-introduced legislation compelled banks to “ringfence” their UK operations from their international and investment banking divisions. The reforms have left some lenders, most notably HSBC, awash with tens of billions of pounds of liquidity that they are deploying in the mortgage market, resulting in a price war in property loans.

Even those banks that are geographically diversified, like HSBC, which generates about 80 per cent of its profit in Asia, could struggle to offset the impact of the US-China trade war and the escalating protests in Hong Kong. Roughly 25 per cent of HSBC’s revenue in Hong Kong is at risk if the city succumbs to a long-term recession, according to one person briefed on its finances.

“Everyone is fixated on the massive revenue pressure,” said the large investor. “There’s a huge [difference] between what they expected and the reality.”

The revenue pressure threatens to widen the gulf that already exists between Europe and the US, where banks generate nearly ten percentage points more in returns than their European counterparts, according to a McKinsey report published on Tuesday. For North American banks, the average return on equity was 16 per cent last year versus 6.5 per cent for their rivals in western Europe, the report said.

“Fundamentally, the difference is on the revenue side,” said Chirantan Barua, a McKinsey partner who co-authored the report. The US benefits from higher interest rates, lower taxes and better loan growth, he added. “The US is one of the few areas that you’ve seen loan growth above nominal GDP, whereas in Europe, across all markets, it’s been below.”

Given that European banks have relatively little control over the external forces hurting revenue, many chief executives have focused on cost control to shore up profitability. Investors expect more to come. HSBC recently embarked on an efficiency drive which, together with potential disposals, threatens up to 10,000 jobs. Shareholders also expect UniCredit, Italy’s largest lender by assets, to announce further cuts when it unveils a new strategic plan in December.

But some investors and advisers fear that banks are close to exhausting their cost-cutting options, having already reduced their headcounts by thousands through early retirement schemes, and by not replacing staff that leave. In some countries, banks are facing cost inflation pressures: in Germany, Verdi, the trade union, has called for a 7 per cent pay rise for 12,000 employees of Postbank, the former post office bank that Deutsche Bank acquired more than a decade ago.

“The unions have banks over a barrel, because banks can’t afford the redundancy costs,” said an investor in Deutsche, arguing that the lender does not have enough capital to take a string of charges to cover severance payments.

New global rules on capital, known as Basel 4, are also expected to put pressure on banks when they are phased in between 2022 and 2027. According to a recent report from Citi, if the rules were in place today, European banks would face a capital shortfall of €130bn, excluding various measures that banks and regulators could take to mitigate the impact.

The new requirements could cut the amount of excess capital that banks return to shareholders via buybacks and dividends, with payouts at UBS, RBS, HSBC and Lloyds at risk, according to the Citi report.

“We feel like Basel 4 has been forgotten to an extent in all the discussions of how low interest rates can go and whether they’re dragging down bank profitability,” said Stefan Nedialkov, a banks analyst at Citi, who authored the report.

Mr Nedialkov noted that the impact of Basel 4 is already being felt as some national regulators introduce tougher rules ahead of the deadline. For instance, earlier this month, the Dutch central bank announced that it would make banks hold additional capital against residential mortgages, increasing their requirements by about €3bn.

Some bank executives say tougher capital rules will make the sector even less attractive to investors, arguing that the implementation of Basel 4 in Europe is more punitive than in the US. Jean Pierre Mustier, chief executive of UniCredit and president of the European Banking Federation, points to a recent study by the European Banking Authority, which shows that Basel 4 would reduce the core equity tier one capital ratios of Europe’s eight largest banks by 27 per cent. A separate study estimates the impact on US banks at 5-6 per cent.

“It will make, over time, European banks less attractive,” warned Mr Mustier, who recently called for an urgent review of banking regulation in the eurozone. “[Banks] will have to pay more for capital — debt and equity — so they will be less able to serve and fund European clients.”

Mr Nedialkov said: “The question is . . . are the European banks going to be successful in their lobbying efforts to try to mitigate the impact as much as they can?”

Besides pushing authorities in Europe to show “regulatory forbearance”, banks are running out of options to protect profitability. That is why some M&A bankers are predicting a string of deals to consolidate the sector.

Although cross-border mergers are still seen as too complex, many advisers expect a series of domestic transactions, especially in Italy, where UBI Banca is seen as a potential consolidator, according to one Italian bank chief executive.

Some bankers also think that the ill-fated attempt to merge Deutsche Bank and Commerzbank, which was abandoned in April, could be resurrected. One said that Commerzbank’s recent strategic plan was tantamount to a “metaphorical white flag”.

The authors of the McKinsey report say that “business as usual” cost-cutting will not be enough to save European banks.

Citing the experience of the car industry in the 1990s, they argue that lenders must take a more creative approach to costs by rapidly introducing automation. And they argue that banks should outsource some tasks, such as checking their customers’ bona fides, to newly-created utilities that could do the work on behalf of multiple lenders.

But achieving such a radical transformation will be no mean feat under the wary glare of investors that are already losing patience. “Since May, all we’ve had are awful conversations about the banking sector,” says one banker who advises several European lenders. “Bank executives are just exasperated.”