European banks improving performance but remain behind the game

The European retail banking sector has seen its operations improve since the hard times that followed the 2008 financial crisis, with the Nordics in particular as star performers. However, profitability per customer and cost-to-income ratios remain lower than pre-crisis levels and, according to a new analysis, banks will need to work hard to improve their performances to meet RoE expectations of 15% or more.

The European banking industry remains under a cloud since the financial crises came close to spelling out unprecedented financial catastrophe. While the sector was bailed out, the effects of the crisis continue to linger within the industry and Europe more widely. As it stands, conditions remain relatively tough for financial institutions — as persistently low interest rates, higher capital requirements and changing customer expectations introduce a range of challenges. In addition, many incumbent banks are still operating legacy hardware and software at a time in which FinTech players are leveraging the latest technologies to woe customers.

In addition, banks also face a lacklustre macroeconomic environment in Europe, as growth rates remain sluggish. Europe’s gross domestic product (GDP) growth rate was 0.5% in the first quarter of 2015, but slipped to 0.4% last spring and was at 0.3% by the second half of the year. There is some good news, however, with low energy prices and low interest rates promoting the capacity for consumers to spend; consumption has been positive over the past two years while nominal disposable income increases are on the rise.

The new normal
A.T. Kearney’s latest 'Retail Banking Radar' study, which involves a study among 90 retail banks in 22 European countries, sheds light on the latest trends across the continent. The Western European banking industry had a relatively uneventful year in 2015, while profitability was up 18% due to a continued reduction of risk provisions, as banks clean up their balance sheets and remain cautious about new risks, revenue was relatively stagnant at 2.4% higher. At the same time, operating costs and cost-to-income ratios remain high, with no real improvement since 2008. Headcount has continued to decrease, down a further 1% last year and 8% down on 2008; many of the lost staff were lower level branch employees, which have been replaced by a few higher level, more expensive, IT staff — resulting in little benefit in staffing costs.

Branch closures
The development of digital channels through which customers are able to perform a range of services, for themselves, have been on the increase in recent years. While the service benefits customers by way of improved efficiency, for banks it also meant that they could rationalise away the branch as footfalls fell.

Particularly Western European countries have seen significant falls in branch numbers, in the Benelux regions for instance, numbers fell by almost 12%, while in the UK there was a 10% drop. In Southern Europe, which has considerably higher density for branches per inhabitant, an average fall of almost 25% was noted — mainly due to Spain’s large drop.

Post-crises levels
The cut in branches and their overheads has not resulted in a significant cost reduction for banks over the past years, with many banks still underperforming from prior to the economic crisis. In terms of cost-to-income ratio, prior to the crisis the average stood at 60%, while in 2015 it came in at 62%. Profit per customer averaged €201 in 2015, well down on 2007 when it stood at €210.

The numbers for 2015 do reflect improvements on the year previous, however, as risk provisions relative to total income fell to 8%, while income per customer was up from €650 to €665 and income per employee was up from €230,000 to €244,000. The biggest change was in net interest income relative to total income, due largely to changes in European wide rates.

Regional retail
The research also took a more granular look at the retail banking segment across various countries. Western Europe’s retail banking industry, the report finds, enjoyed rosy results last year — profit per customer increased by 9%. However, there are different sides to the story. Austria, Benelux, and the United Kingdom saw strong increases of between 11% and 29% (net of exchange rate effect in the United Kingdom), while France posted a more moderate 6% gain, and Germany had a small loss of minus 3%.

In Southern Europe significant improvements were booked last years as banks saw profit per customer surge 157% to €134, backed mainly by a 12% reduction in risk provisions, the strongest in Europe. The region is still well behind its pre-crises levels, however, when profitability per customer was above €300 — the region is dragged down by still-low income per customer (14% below 2007) and higher risk provisions related to total income (11% above).

The top performers last year were the Nordic retail banks, which managed impressive cost-to-income ratios of 48%, which boosted profitability by 9%. Nordics also enjoy a favourable market environment with even lower loan loss provisions compared to 2014, as well as a digitally adept populace.

Championing cost
The analysis further considers a more complete interpretation of cost comparison, which it calls “total efficiency ratio” (TER), calculated by cost-to-income ratio plus loan loss provisions/income. If a bank operates in a low risk environment with minimal loan loss provisions (LLPs), this will equal its cost-to-income ratio; if it operates in a market confronted with high LLPs, its cost-to-income and operational efficiency need to be even more ambitious.

According to the analysis, RoEs of 15% or more will require a TER of less than 60% – which means only the Nordics currently support such conditions  Other countries and regions with the lowest TER include Switzerland and Central Europe. The Benelux has a ratio of 63%, while the UK has a ratio of 65%. Southern Europe has a collective ratio of 87%, with Portugal on 92%.

The consultancy firm concludes its analysis with three measures which could improve the level of performance of European retail banks: (1) cost transformation, which probably needs to account for half of the improvement; (2) higher income per customer, which unlikely will come from higher interest margins and probably has to stem from new services, upgrading of customers and products, and re-pricing of core products like accounts and cards; and (3) strict risk discipline and effective cleaning-up of non-performing loan books.”