European Banking Sector: Resilience and Opportunities in a Challenging Landscape

Piotr Sobolewski, XYZ: On 20 January, the European Banking Authority (EBA) and the European Central Bank (ECB) launched a banking sector stress test. Will it prove in the test that it is resilient to economic and market turmoil?

Philipp Wackerbeck, global head of financial services at Strategy&: I think banks have made a lot of progress over the last 10-12 years, so today, we can say that the banking sector is quite resilient to possible risks.

Stress testing examines how banks will perform over three years, depending on implementing different scenarios [baseline and extreme-ed]. Banks are in a much better-starting position than they were a decade ago. They have both higher equity and higher profitability of their business, allowing them to deal effectively with possible credit losses or rating downgrades. 

I think we already saw this resilience in 2023 when Silicon Valley Bank collapsed in the US and Swiss Credit Suisse [eventually taken over by UBS - ed] had problems in Europe. As this happened in the US, investors in EU banks were not too nervous, and we didn't see pressure on banks to withdraw deposits en masse. 

What would be the most significant risk to banks' operations in the European Union? This year's extreme stress test scenario mentions geopolitical tensions or another wave of protectionism.

Uncertainty related to the geopolitical situation. We are not talking about sudden conflicts or outbreaks of successive pandemics but rather an ongoing tension that alters many other trends and phenomena, e.g., through deglobalization and trade wars, which reduce the cooperation of economies and thus decrease the scale of international trade.

Such trends affect two things: they raise inflation and slow down economic growth. High inflation, in turn, influences the need to keep interest rates high at a time when a cut would be needed due to low GDP growth.

It must be added that, globally, China is no longer growing as fast as in the past. On the other hand, Europe needs to solve the slow growth problem. It is mainly Germany at stake because, without this country, it is difficult to relaunch the European economy.

Polish banks - Pekao and PKO BP - have a good track record in stress tests. For years, they have ranked among the banks least affected by extreme scenarios. Could it be similar now?

There has been a clear divide between the north and south of Europe. The former tended to be less profitable but had lower loan losses and a percentage of loans not repaid on time (NPLs). In the South, the opposite was true. Now we see that the situation has changed, and in Germany, for example, we see a growing number of NPL loans, although this country has not previously experienced such issues on a large scale.

From this perspective, Poland seems to be quite an attractive market. It is very profitable and has a sizeable domestic capital base. The challenge, however, could be that Poland is heavily dependent on Germany, which is, after all, its largest trading partner. As a result, Poland will be dragged into some broader adverse scenario. This is something to watch out for. 

You mentioned the problems of the German economy. What is it facing right now?

Above all, we are looking forward to the new parliamentary elections, which will take place on 23 February 2025. This is good news for the economy, as the previous government did not succeed in fixing structural problems.  But such fundamental reforms are needed, whether in the labor market, social spending, or the ability to jump-start investment.

I think Germany can and should invest a lot more, but it has to do so productively, targeting investments in infrastructure, digitalization, or education. You also have to invest in the defense industry, which is not easy because, for 30 years, this sector has been limited. If this does not change, Germany will still depend on the US. This is precisely the task of the new government. 

How do we accelerate such investments?

The debate in Germany is currently very much centered around the debt break and if it has to be released or not. However, releasing the debt break is not a silver bullet, but rather a measure that – even when the means are invested productively – raises other issues. It is more important and ultimately more impactful to channel more private capital into the major transformation areas. Europe and Germany in particular need more equity participation, for example. More investors, private and institutional need to provide growth capital for European corporates, and for retail investors this may require some sort of government sponsored incentives, like successfully done in Sweden or in the US.

Does Germany understand the need for change? 

This is one of the key questions. One problem may be that people generally live well, and voters may only decide to make more fundamental changes by feeling some negativity.

The second key question should be who voters trust enough to believe will solve these structural problems. We are already observing the election campaign, and it turns out that the political parties promise very little, which is the complete opposite of traditional campaigning. So it remains to be seen how much they can and will improve the German economy once in power.

Today, many CEOs of companies or banks in Germany are optimistic, but I don’t see economic evidence for this. There are far more indications to be pessimistic. The only upside is that Germany usually comes out of such problems stronger, which could also be the case this time. 

Will investment in energy transition still be essential? After all, Europe is seeing moves by US banks to withdraw from the Net-Zero Banking Alliance (NZBA) or Donald Trump to pull out of the Paris Agreement.

I think this will continue to be one of the most critical issues for the European Union. It can be split into two parts. The first is energy security, which we must finally treat as a priority, which has not been the case. We need to think about what the energy mix should look like and how it should change, considering the growing demand for electricity resulting, for example, from the use of artificial intelligence or bitcoin mining. 

In my personal opinion, we must finally stop treating this subject ideologically, as is happening in Germany, which has withdrawn from nuclear power stations precisely for ideological reasons. The truth is that we are today dependent on others for this. Until now, this dependence has not been significant, but it becomes crucial when something sinister happens in the world. 

How can this be changed? Is it about some significant investment in wind farms or photovoltaic panels?

Again, there is no simple answer. It’s about defining the right energy mix that tries to best manage the balance between competing targets. Energy security and energy prices have suddenly become very important factors for long-term investment decisions, and we have to provide workable solutions in an unideological way.

You talked about two factors. What is the second one?

These are actions to reduce the impact of climate change. I am more optimistic about this, and the issue is not black and white as portrayed by the new US administration. I see Europe being seen globally as a positive example of taking climate action. At the same time climate change is already having a significant negative impact as data from the (re)insurance industry tells us. 

As far as the withdrawal of US banks from the NZBA is concerned, let's remember that in significant US states like California or New York, banks still have to comply with requirements related to ESG, for example, because it is up to the states, not the federal government, to make that decision. You cannot do banking business there if you do not meet these criteria. 

Let's go back to this energy security. Are banks needed to implement this plan?

Germany depends on international free trade; if this changes, it must adapt. It is undoubtedly advantageous for Europe that two-thirds of trade takes place in Europe. As a result, Hungary, for instance, has a bigger trading volume with Germany than Japan has with Germany. The best way to improve energy security is to have a strong Europe to get a better position in this world, fragmented by the US and China. The stronger we are as Europe, the better, and every country, not just Germany, must significantly contribute to this. Like all sectors, the financial one must be involved in building this energy independence as this is a costly endeavor that requires a substantial amount of capital. Banks play an important role in facilitating this.

For this to be possible, we need strong banks, which require pan-European mergers and acquisitions. How do you build big banks?

In recent years, there has been a growing realization that we need big, strong banks. Only such institutions could stand up to the US banks that dominate the global landscape and lead European transactions. Just look at capital markets transactions, investment banking, and everything that helps the economy to grow. We need strong European banks in place at a strategic moment of growth in investment needs. 

I think the groundwork has been laid in recent years to enable pan-European M&A in this sector. One such thing is the ECB's position on recognizing negative goodwill [badwill, a situation where a company is acquired below its book value]. In such a situation, the bank is obliged to recognise badwill through the income statement, leading to a one-off favourable impact on the result. The ECB was against this practice for years, but during the COVID-19 pandemic, it changed its stance. Therefore, if a bank has a low valuation and is acquired below book value, the acquirer has a large financial incentive to bring about such a takeover. 

Have there been any more regulatory incentives for mergers and acquisitions in the banking sector?

I don’t think there should be any additional regulatory incentives for bank mergers including cross-border mergers. Regulation should provide a level playing field for banks and for the market to determine if a combination, especially cross-border, makes sense. More importantly, there shouldn’t be any disincentives from an overarching European perspective, which we don’t think there are. However, there are still a lot of local specifics in terms of domestic application of regulations, legal frameworks etc. that don’t allow banks to fully exploit the potential of cross-border mergers. But in general, from our perspective there are no fundamental showstoppers, and shareholders have to decide if an individual combination makes sense or not.

The example of UniCredit and Germany's Commerzbank shows that a key obstacle is the interests of individual governments, the reluctance to have one of the leaders in a given country in the hands of a banking group from another one.

I can't comment on individual transactions, but only from a general point of view. I think the key is to convince stakeholders that any deal makes sense and is worthwhile to pursue. It should happen if the benefits outweigh the downsides and if there are no fundamental showstoppers.

But they will be because they are expected by a part of the electorate, especially just before elections and when talking about the TOP3 banks in the sector. Is it somehow possible to limit the influence of politics on such transactions?

Politicians' interference in market processes has traditionally not often been helpful. But clearly when governments are shareholders, they have a vested interest and have the right and obligation to articulate their perspective as shareholders. 

Perhaps what needs to be more competitive and significant is not pan-European mergers but more liberal regulation for the banking sector.

This is an interesting question because I remember five or six years ago, there was already talk that introducing new regulations resulting from the financial crisis had to stop at some point. Unfortunately, that never happened. I think many would agree that many regulations implemented after the financial crisis have improved the resilience of the banking sector. But at the same time they have hit the competitiveness of the European banking sector compared to other parts of the world. In the end, the best protection for a bank is a sustainably profitable business model that is able to absorb certain shocks that we see nowadays more and more.

We need to think about the scale and scope of regulation. We may need less, but partially better regulation. Over-regulating the industry doesn’t help as we already see a lot of business shifting from a highly regulated banking industry to less or non-regulated markets. This may increase the resilience of the banking sector at first sight, but not the resilience of the financial system as a whole. Today, I guess it’s fair to say that the European Union is excessively bureaucratic, and institutions report many things that are not always useful or where the relevance is questionable. And this is the difference between the EU and the United States. Overseas, institutions report a lot of things, too, but they get a lot of feedback from supervisors, so they know the use of the data they report and they get more feedback how to improve. A great example is ESG-related reporting and the CSRD. From many banks’ perspective, the European Union has gone too far with this regulation.

Therefore, in the European Union, we should be more careful when creating new regulations and more critical when reviewing existing ones. We pay too much attention to creating new rules imposing new obligations, and financial institutions have to invest too much energy complying with these demanding regulations. They are hiring more people, not to increase business and investment but to meet all these requirements imposed on the sector.

What happens if European banking champions do not emerge?

Other banks will begin to play a key role in international financing. It is not only about American but also Chinese, Japanese or South Korean banks. We already see statistics showing that the role of European banks in global financing is steadily declining. In many areas, banking has become more and more of a scale game, just think about the huge amounts that need to be spent on technology transformations. Banks need sufficient investment power to address these requirements and to transform their legacy infrastructures. For example, when you look at the IT spent of banks in the US, 60% is on change while 40% is on running the bank. In Europe, it’s only 30% on change, and thus the technology gap is rather widening which has again negative implications on the competitiveness of the European banking sector.

Speaking of regulation, one cannot help but ask about banking unions. Because of national conflicts, we still have not completed the third phase, the European Deposit Guarantee Scheme. Is this even necessary today, or would it be over-regulation?

This question continues to be heavily debated and there are valid arguments on both sides. I guess if we really want to integrate, scale and strengthen the European banking sector, there is merit in completing this part as well. But I do also understand the arguments of the opponents of a European Deposit Guarantee Scheme.

Banks are one thing, but a capital markets union has been in the works for years. Do we need this?

Yes, we clearly need stronger and more integrated capital markets. Financing in Europe today relies heavily on banks. We need to involve other investors more into the need to finance the two major transformations: the sustainable transformation and the transformation of our traditional European economic model. To do so, we need better functioning securitization markets, we need to allocate more private capital into the market, specifically into the equity markets. What needs to happen is encouraging people to invest their savings in the capital markets. For this to happen, we need, for example, tax incentives like in Sweden or in the US. These are, by the way, also key recommendations in the Draghi or Noyer reports that were issued last year.

And do we need to create new pan-European products for this? The example of the PEPP (individual pension product), whose only supplier in the Union is the Slovakian Finax, shows that the regulators' vision is not reflected in reality.

Indeed, there have been attempts by the European Commission to provide a framework for pan- European investment or pension products, but the concept didn’t really get a lot of traction in the market. One of the key reasons, as often, is over-regulation of the products and in some countries a well-meant consumer protection which is costly and hampers the attractiveness of products. Thus, the simple answer is that such pension products need to be simple, they need to be produced in a cost-efficient way and deliver clear benefits for consumer respectively investors. And, as we have seen in other countries, if governments can set positive incentives, this will surely also drive broader market adoption.

Is there any reason to be optimistic about the economic future of the European Union?

Yes, we have great people and much capital that needs to be deployed differently. For example, we are an attractive place for people from outside Europe to invest money here. We may not be one of the fastest-growing markets in the world currently, but I count on us to remain one of the best places to be. We need to overcome some current challenges.