The shake-out that will follow the pandemic provides European lenders with an ideal opportunity to remake their businesses.
As Europe prepares for its biggest recovery plan since the second world war, most banks bear scars from the long Covid-19 shutdowns. Many European banks were limping along even before the pandemic. Now each bank faces a classic choice: whether to use a crisis to remake their business and return to growth or stick with their current model in the hope of an inertial recovery.
Economic crises have always been moments that reshape entire industries. After the last financial crisis, top-quartile banks, as measured by pre-tax earnings, outgrew the bottom quartile by nine percentage points each year of the past decade, according to Capital IQ data.
Economic crises have always been moments that reshape entire industries
An immediate challenge is to isolate and neutralise the effects of the imminent surge of bad loans. According to our analysis, the flow of new non-performing loans (NPLs) across Europe will total between €0.9tn and €1.2tn, starting near the end of 2021 and following through to 2022, when governments lift the suspension of loan repayments.
This amounts to a sizeable hangover, but a manageable one if banks take a proactive stance. Banks will need to identify which parts of their loan portfolio feel the most stress, and cluster those loans according to factors such as state guarantees, the share of wallet each customer spends with the bank, and the loan-loss provisions that are in place. Each cluster will require a tailored programme to deal with the bad loans within.
Troubles before the storm
Beyond that pressing challenge, European banks must contend with other deep-seated concerns. The sector has suffered for years from a low return on equity (ROE) — around 5% both in the EU and the UK in 2019, and well below the average cost of equity. ROE dropped further in 2020. The cost-to-income ratio, meanwhile, has been stuck at around 66% on average.
Behind these numbers lie several problems. First, there is a wide digital gap between young neobanks and traditional banks, which limits the latter’s performance in cost, speed and the customer experience. And second, profitability has evaporated in traditional revenue pools, such as commercial loans of more than €250,000.
Five imperatives for recovery
Once banks have developed a robust plan to deal with NPLs, they should turn their attention to five broader actions to deal with these structural concerns:
- Accelerate digitalisation. All traditional banks have launched digital initiatives, of course. But with customers increasingly buying financial services products from fintechs and large technology companies, it is important for bank executives to honestly assess the speed of their digital progress and accelerate investments in the areas that matter most to customers and to the bank’s economics.
- Control costs sustainably. A sustainable long-term approach depends on senior leaders setting the ambition and employees at all levels surfacing cost-reduction opportunities. A culture of zero-based budgeting starts with a clean sheet on spending, rather than assuming “last year’s budget plus or minus x%”. There are two functions that deserve special attention: with work likely to occur at both home and office locations, banks should rethink their use of real estate, to eliminate non-functional spaces and optimise functional ones. In addition, banks should capture savings through smarter use of digital tools, such as straight-through processing (using automation).
- Find new avenues for profitable growth. As revenue pools have shifted, many bank executives have been shocked at the extent of profits draining away. Facing up to the reality, therefore, is an essential prelude to making the most of opportunities that emerge from the recovery. In Italy, for instance, Intesa Sanpaolo recently announced it will double down on its recovery plan by making available more than €400bn of resources, focusing principally on initiatives related to the themes of green transition, infrastructure and critical supply chains.
- Turn sustainability into a business proposition. Increasingly, elements of sustainability are figuring as key components of growth in banking. Products and advice related to issues such as decarbonisation and climate risk will mean reconfiguring internal processes around risk management, the supply chain and real estate. Far from being only a matter of compliance, achieving a sustainable profile can translate to better bank economics and greater resilience.
- Step up consolidation. European banking remains too fragmented. As of 2019, the top three players in each market owned no more than 50% of deposits. The pace of M&A is bound to pick up, given that assets are relatively cheap right now. Domestic deals involving smaller banks will respond to cost and regulatory pressures. Opportunistic cross-border deals will surface due to the push by regulators for larger, healthier institutions. And some deals will expand a bank’s scope by acquiring fintechs whose valuations have fallen.
Sometimes it makes sense to pause, but not today. Banks that take this moment to deal with the key challenges and opportunities outlined above stand a far better chance of thriving once the pandemic has passed, and building a durable competitive advantage no matter what new challenges emerge.
Roberto Frazzitta is a partner at consultancy Bain & Company.
