Luis de Guindos, Vice-President of the ECB spoke at the Annual General Meeting of the Foreign Bankers’ Association, which was held in Amsterdam the 15 November 2018. The focus was the state of the euro area banking sector and its current challenges.
The financial health of euro area banks has improved markedly since the beginning of the crisis. The aggregate core capital (Common Equity Tier 1) ratio of euro area banks stood at around 14% at the end of the second quarter of 2018, the double of what is was in 2007. Regulatory liquidity ratios are at solid levels, with an aggregate liquidity coverage ratio of 141%. European banks are also making progress in fulfilling the minimum requirements for own funds and eligible liabilities (MREL).
One indicator of this is that the volume of Additional Tier 1 bonds and Tier 2 instruments issued by euro area banks and held by investors in the euro area increased by two-thirds between 2013 and 2017. Finally, banks are also making progress in repairing their balance sheets – the aggregate non-performing loan (NPL) ratio has nearly halved from its 2013 peak of around 8%, to its current level of 4.4%.
The recently published results of the 2018 stress tests reflect exactly this. On average, core capital of euro area banks after stress stood at 9.9%, up from 8.8% in the same exercise two years ago. Underlying the results is the strong build-up of capital buffers in recent years resulting in a better condition at the starting point of the exercise (end 2017).
While euro area banks are clearly better capitalised and more resilient, this exercise should not hide the fact that areas of vulnerability remain. In particular, banks are still struggling to achieve sustainable profitability. Admittedly, headline profitability figures show that the sector seems to be improving rapidly – the average return on equity for euro area banks increased from 3.4% in 2016 to 6.9% in the second quarter of 2018. However, more careful analysis reveals that this improvement is mainly due to a reduction in the cost of credit risk. This results, in part, from a cyclical upswing that has stemmed the flow of new NPLs and led to provisioning costs falling to post-crisis lows. At the same time, operating profits have remained modest overall and the average cost-to-income ratio flat at 66% over the same period, reflecting some cyclical and structural challenges.
On the cyclical front, banks are finding it hard to increase their revenue in the low interest rate environment. Although credit growth has increased somewhat with the improving economic conditions, it is not yet sufficient to compensate for the low interest rate margins. The continued economic recovery should, however, reduce the negative impact of cyclical factors over time, as banks’ balance sheets adjust.
But most importantly, a number of structural challenges continue to dampen bank profitability. These factors vary across countries and banks and include incomplete business model adjustments, cost inefficiencies and excess capacity. The stock of NPLs also remains high at some banks.
On the positive side, the growing economy and the ever more resilient banking sector are supporting financial stability. This is partly why the financial system has recently proved resilient to volatility, and why contagion across countries and markets has remained limited. But these developments need to be put into the context of the continuing search for yield in the markets, rising trade protectionism, and political and policy uncertainty, which increase risks to financial stability.
Taking these factors together, the euro area financial sector is faced with risks, which can be classified in three categories. First, the factors that are related to the past, in other words, the legacy of the crisis, include a still-significant private and public debt overhang. Second, the current expansion of the US is now significantly longer than historical norms and the second longest in US modern history. Third, in Europe, debt sustainability concerns have risen both in the public and private sector. As regards public finances, Italy is the most prominent case at the moment in light of the overall debt level and the political tensions around the Italian government’s budget plans. Contagion to other European sovereigns has however been limited.
In sum, there is no reason to be complacent about financial stability risks in the banking sector, which could materialise in a number of ways. At the current opportune moment with 22 consecutive quarters of economic growth behind us, minds should be concentrated on tackling structural impediments to sustained profitability in the euro area banking sector.
Banks need to adjust their business models to further diversify their income and reduce cost inefficiencies. They should also prepare for the challenges of digitalization and competition from technology companies. And it is of the utmost importance that the large stocks of NPLs that still remain in some banks are reduced.