At least the ECB thinks profitability is a good idea…

Strangely enough, in a recent article on its website (“Profitability numbers are looking up, but not enough”), the ECB took the view that profitability, at least for the European banks which it supervises, is a good thing, making the point that, even though bank profitability “improved slightly” in 2018, the ECB remained concerned because “profitability levels are still low”, and that stated numbers in isolation do not provide sufficient evidence of sustainable business models.

In what seems like a direct challenge to views in certain quarters (see our previous post “Profitability? How quaint!), the ECB also stated: “Moreover, profitable banks are more attractive to investors”, also pointing out that the average return on equity, at 6.4% in 2018 (from 2017’s 6.1%) is too low, and in many cases below a banks’ cost of capital.

Of course, as we have repeatedly emphasized, if a business cannot generate sustainable profits that provide a margin that exceeds its cost of capital, and allows for re-investment to promote resilience and growth, absent constant infusions of fresh capital, it will eventually fail.

It may be that “traditional” fractional reserve banking is not seen as sufficiently “sexy”, with no-one likely to brag on the cocktail circuit about their position in “Standard Eurobank” (although Warren Buffett would beg to differ when it comes to US banks). Nevertheless, unlike VC-backed “fintechs”, many, if not most of which, will fail or otherwise disappoint, the EU’s (and other countries’ core banks) remain essential to the functioning of their underlying economies. If their viability is threatened, the consequences are potentially serious- one only has to look at the Great Financial Crisis (GFC) and its aftermath for that.

So, it is worrying that many EU-based banks are still unable to generate adequate levels of profitability, even though the level of impaired assets and, thus, provisioning has declined to very low levels. Not only that but, as the ECB commented “on aggregate, operating costs marginally increased in 2018”. All this begs the question, in an increasingly fraught economic environment, with growth stagnant or declining in core EU jurisdictions such as Germany, of how much ability local banks have to withstand the next downturn. They may be better capitalized, and have lower leverage than before the GFC, but their inability to generate adequate returns rightly troubles the ECB.

This also leads to the paradox that the regulator wants the banks it supervises to make strong profits and an attractive return on capital from sustainable business models, yet, through a combination of tougher capital requirements and a monetary policy that suppresses achievable margins, makes that goal ever more challenging. One should not feel sorry for the bankers, as those who are pro-active, flexible and bold should always be able to prosper, but it does raise the prospect of “zombie banks” remaining a drag on the entire economic system.

Awbury has deep knowledge and experience of helping banks globally manage their capital needs, as well as address their portfolio risks, whether on- or off-balance sheet. We always welcome the opportunity to discuss how the suite of products we have developed may assist managements in achieving their targets.

The Awbury Team

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