Time for radical change
European banks face yet another period of uncertainty. They have been remarkably resilient in the face of the Covid-19 pandemic, but will continue to be affected by the variable pace of growth in the global and European economies. Both national governments and the European Central Bank (ECB) have stepped in with a battery of extraordinary actions to soften the economic blow of the pandemic, but as these measures are phased out, more businesses will go under and unemployment will remain stubbornly high.
This will force some banks to book higher loan loss provisions and deplete capital buffers, and could ultimately affect their ability to provide enough financing to support economic recovery. The pandemic has exacerbated other challenges already affecting European banks, whose share prices have lagged behind the wider market for more than a decade despite a strong start to 2021. Costs are simply too high in an era of zero or negative interest rates, and bank returns are below their cost of capital. The Covid-19-induced economic contraction has put even more pressure on the bottom line, and the demand for loans remains uncertain, according to the ECB.
European banks must act now to close the long-standing gap between their earnings and the cost of capital by radically rethinking their business strategies and comprehensively repositioning themselves, particularly in the areas of credit, cost, consolidation, technology, and ESG.
While the rebound in sector share prices in 2021 is highly encouraging, banks cannot afford to be complacent. The challenges they face are formidable, and to emerge stronger from the crisis, banks must radically transform their cost base, streamline their operations and consider mergers, including cross-border deals, more seriously.
In addition, the scale of the technological transformation of financial services over the past decade cannot be overstated, and banks can no longer take customer loyalty for granted amid competition from FinTech and BigTech players. This change requires all bank operations to be run from a solid digital platform. Banks will also have to provide environmental, social and governance (ESG) disclosures to build the sustainable models demanded by customers, shareholders, regulators, employees, ratings agencies and other stakeholders.
European banks will struggle to catch up with their stronger US and Asian peers without radical change. Banks must act now to address these challenges head-on through a profound transformation of their business models. The goal must be to close the yawning gap between bank returns and their cost of equity.
There are actions to take in at least five key areas, all of which directly impact bank profitability. In a series of detailed deep dives, we set out actions to take in those five key areas. None of these areas are new for banks, but they must be revisited and reviewed rigorously with a view to taking decisive strategic action.
Understand the dynamics of the recovery across different markets and industries to prepare for any rise in loan defaults by identifying the key risk drivers, and devise strategies to conserve capital. Reassess risk appetite across different sectors and asset classes.
Plan a strategic review that radically transforms the business, with potential to reduce the cost base by up to 40%. Reallocate scarce resources to more profitable lines of business.
Undertake a thorough analysis of potential transactions ahead of an expected wave of deals.
Develop a digital platform that is scalable and offers customers personalized digital services, while making the organization more flexible and agile.
Craft a truly sustainable business model that measures success with KPIs that are part of overall executive incentive schemes.
The goal must be to close the gap between returns and the cost of capital. In the short term, this means managing the risks associated with an uneven economic recovery on the loan book. That requires a more flexible approach to adjust how loans are originated and held, moving toward a more “asset light” model.
Banks must also undertake a radical review of their cost structure in a transformation that will affect every aspect of the bank. Cutting costs and improving returns would free up funds to make the investments in the technology needed to compete with BigTech and FinTech competitors, and meet customers’ new expectations when it comes to convenient and secure digital banking.
The ECB’s new guide has already encouraged domestic mergers in Italy and Spain, and banks should be actively considering cross-border transactions where scale or added capabilities offer a clear competitive advantage. Other banks may seek strategic alliances with rivals that have similar business models to combine them on a single platform, or pursue partial mergers.
ESG considerations must also be an integral part of any radical bank transformation. This is not just about meeting legal requirements and becoming carbon neutral, but rather understanding ESG as an opportunity to enhance reputation, de-risk loan portfolios, increase engagement with stakeholders and attract talent.
Real change necessarily involves rethinking the entire business model, which will lead to a massive transformation within the workforce, in terms of working models and the skillsets required. The sooner eurozone banks begin their transformation, the sooner they can close their long-standing performance gap.
Marwin Schmidt also contributed to this report.