How to Make Banking Profitable Again?

Mergers, diversification and new uncertainties at the 12th Banking Industry Meeting

16/12/2016 Madrid

Fernando Restoy | IESE Business School
Fernando Restoy, deputy governor of the Bank of Spain: “The restructuring of the banking system is the fruit of collective endeavor” / Photo: Javier Arias

Despite reforms over the last few years, the banking industry remains“notably vulnerable.”

On average, European banks' return on capital stands at below 6 percent­. Moreover, new uncertainties are buffeting the sector, in the wake of Brexit, the U.S. presidential election results and the hold-up in comprehensive banking union in the E.U.

Mergers, greater efficiency and increased diversification will be required to turn the situation around.

This was one of the main conclusions of yesterday's 12th Banking Industry Meeting, organized by IESE's Center for International Finance (CIF) and sponsored by EY.

Authorities from the Bank of Spain and executives from the country's leading financial institutions gathered to examine the big issues and hear from IESE faculty, Juan José Toribio (the meeting's academic director) and Jorge Soley.

Looking Beyond the Short-Term

Fernando Restoy, deputy governor of the Bank of Spain, attributed low profitability to “depressed net interest income” and a build-up of “non-performing assets” on banks' balance sheets during the recent economic crisis.

Using fees to boost margins is a possible solution, but this strategy has not been applied enough yet. In the first half of 2016, fee income was 5 percent lower than last year.

And this isn't just a temporary state of affairs.

Even if the ECB normalizes its monetary policy, says Restoy, “growing competition”, the role of capital markets as an alternative source of funding and the increased capital requirements introduced by regulators will bring additional pressure to bear on the industry.

Strategies for Survival

So who will make it and who will be the casualties of this situation?

Economic and regulatory conditions could enable “small-scale” banks to survive, as long as they engage in community banking, making the most of their proximity to “very specific” customers.

The Bank of Spain envisages four solutions for what it terms “significant institutions:” pursuing mergers (resulting in fewer banks with more capital); embracing technology to a greater extent; being more active in capital markets; and adopting a more diversified business model, encompassing a wide range of financial services.

Spanish banks have, in fact, already taken a number of steps in this general direction.

Since 2007, says Restoy, there has been a 44 percent reduction in the number of banking groups; over 60 percent of net real-estate exposure has been wiped off balance sheets; and fresh provisions of around 300 billion euros have been made available for outstanding and awarded loans.

There has also been “intense recapitalization” totalling more than 70 billion euros since 2008 at the consolidated level.

The industry has made a huge effort, according to Restoy, and so too have taxpayers.

Citizens, he says, have provided “very substantial resources, equivalent to roughly 5 percent of GDP, to protect depositors and ensure financial stability."

Restoy stresses that the restructuring of the banking system “is the fruit of collective endeavor but we still need to review the way financial supervision is organized and improve the legal system applicable to credit unions."

China, Trump and Brexit

It's not just about profitability, however.

Juan José Toribio and Jorge Soley highlighted a number of geopolitical issues that willl impact the sector, including Brexit and the Trump presidency.

The next two years will be shaped by the way China, the USA and the UK act on the world stage, says Toribio. He predicts that the Chinese adjustment planned for this year will happen sooner or later, and that Trump's rise to power will yield a more moderate expansionary policy, higher real interest rates (as can already be seen in the case of 10-year bonds) and an upturn in the dollar's value “like in the Reagan era”.

In terms of Brexit (and possible contagion), Toribio believes that negotiations with Europe will be marked not only by problems stemming from the pound's falling value, but also by the U.K.'s desire to retain passporting rights and the E.U.'s interest in preserving its trade surplus with Britain.

The biggest goal, however, is avoiding a loss of confidence in the euro at all costs.

Delaying Banking Union at What Price?

Soley is adamant that a harmonization of financial policies across Europe is essential in terms of "reducing the likelihood of bankruptcy and the costs it would entail, as well as protecting deposits.”

Banking union, he says, will go ahead – despite the UK's departure from the E.U. –, although the process will take longer and there will be enormous pressure in relation to establishing a single deposit guarantee scheme because of opposition, particularly in Germany, to the pooling of risk.

Soley also believes that prolonging negotiations between the E.U. and London could cause some banks funding and liquidity problems and prompt the ECB to extend its current monetary policy, possibly until 2020.

On the subject of the imminentcrisis set to engulf part of Italy's banking industry, Soley believes the Italian state will opt for a “semi bail-in”, which will raise doubts over the Single Resolution Mechanism and could, in the long term, generate a credibility problem.

The Challenge of Digital

Carlos Torres Vila, CEO of BBVA, believes that banks need to “digitize customers' trust”, so that they feel as secure performing transactions via a smartphone as when doing so in person in a branch.

“Our business gets much better the further along the digital path we go, as the improvements are cumulative,” he explained.

"In the digital environment 'data architecture' is crucial to making customers' financial lives easier, and helping them plan for their economic needs."