At the end of September 2018, the European Central Bank (ECB) published the findings of its thematic review of banks’ profitability and business models conducted from 2016 to the end of the first quarter of 2018. The review shows that although the economic situation of banks in the euro area has generally improved, profitability and business models remain under pressure e.g. aggregate profitability in terms of RoE was 6.3% in 2017.
Analysis of profitability drivers and business model assessments of the euro area banks has been a major priority for the ECB for some time. In this thematic review, the ECB highlighted in particular its assessment of euro area banks’ ability to strategically steer their business models. This ability to ‘steer’ is emphasized by the ECB and refers to a bank’s management’s ability to set a course towards the bank’s long-term objectives.
The view of the ECB is that common attributes of profitable banks are an understanding of the drivers of their income; access to high quality breakdown of costs by business line; good process for loan pricing including a minimum level of pricing needed to cover all costs and risks (“pricing floor”) and finally an evolved risk framework that links business strategy with an awareness of risk.
Interestingly, the ECB states that “IT budgets have grown by more than 20% over the last five years. However, it is difficult to assess what share of this spending on IT helps banks prepare for the future given the significant issues many banks are facing with their legacy systems.”
The main conclusions of the review are:
- profitability and business models remain under pressure, with the main causes being high impairment and legacy issues. The profitability situation differs widely across institutions. No single sector or business model is outperforming others. However, there is a cohort of profitable banks which the ECB is comfortable with;
- the ECB has identified insufficient strategic steering of profitability as a key problem; and
- there is no one-size-fits-all approach to profitability, as even strategies among the best-performing banks have largely differed with regard to costs and income. Some banks are reducing costs and income simultaneously with no real impact on profitability while in contrast another cohort of banks achieved high profitability by following a high-income strategy with relatively high costs that are more than compensated for by a very strong income-generation capacity.
The results of the thematic review will feed into the 2018 Supervisory Review and Evaluation Process (SREP).
The ECB does not offer too many prescriptive recommendations in their report but an air of scepticism pervades their assessment of bank’s ability to implement strategies. It is clear that they believe further evolution of the risk management framework informing the development of strategy alongside better management information regarding incomes and costs are essential prerequisites to improved profitability.
Furthermore, they perceive a significant role for themselves in assessing and possibly resetting bank strategies, which they perceive as delivering ‘insufficient strategic steering of profitability’. In short, we can expect more activity from the ECB in this area.
Grant Thornton has a dedicated Prudential Risk team in place to complement its existing Quantitative Risk practice, which is the market leader in Ireland. With this focus, Grant Thornton is ideally placed to support banks with regulatory challenges relating to its profitability and business model.