Banking challenges for Europe in 2020

Teunis Brosens

Bankers across Europe are feeling the pressure from prolonged negative interest rates, a challenging regulatory regime and the need to keep pace with customers’ increasingly digital expectations.

The Banker has polled a select panel of industry experts to discuss the impact of these issues on Europe’s banking sector. Participants discussed the measures needed to boost profitability and protect margins in the below zero interest rate environment and the case for regionwide and in-market consolidation.

The pressing need to upgrade legacy infrastructure and scale down costly branch networks remains, as banks continue to reduce costs, transition to digital business models and defend their market share from emerging fintech and neobank challengers.

Basel III/IV, customer due diligence and the revised Payment Services Directive (PSD2) top the regulatory agenda, while the prospects for a regulatory framework around climate risk may become the focus for European governments and regulators during 2020.

The panel also considered the credibility of the threat from 'Big Tech' firms such as Facebook, Amazon and Google. Large technology groups such as Ant Financial, Alibaba and Tencent are beating banks’ retail offerings in China, delivering enhanced customer experiences, and their appetite to push deeper into finance is being seen in other parts of Asia, Africa and Latin America. Whether Big Tech has the desire to make inroads as competitors into a highly regulated European market with deep conventional banking penetration is something the panel considered. 

Q: What is the single biggest challenge facing European banks in 2020?

Chira Barua: With capital levels broadly restored and marginal efficiency gains from cost reductions losing steam, the single largest challenge for the banking system in Europe is the search for elusive revenue growth, especially given anaemic returns at less than 5% return on equity. Monetary policy doesn’t really help, nor does muted credit demand across most geographies. Banks need to head back to the whiteboard to identify where they specifically add actual value for their customers in the retail and institutional space, and find ways to monetise it, be it through optimal pricing decisions based on deep segmentation or through the introduction of more value-added ecosystem plays.

Teunis Brosens: The European banking sector clearly has a profitability problem. The year 2020 will see continued activity by challengers expanding into banking, forcing banks to maintain substantive investments in transitioning to a digital business model. The more acute challenge for 2020 is the negative interest rate environment. Negative rates have been eroding bank profitability since their inception in 2014. Mitigating management actions have limited the impact so far, but room for such actions is rapidly running out. With banks reluctant to impose negative rates on households, interest margins will come under increasing pressure. In addition, the average rate banks earn on their loan portfolios keeps on declining too.

Alastair Ryan: Negative rates: for a bank, what an awful idea they were. Banks raise deposits from people and businesses, basically at zero. The deposits are very stable, because there are millions of depositors, so you can use them for long-term financing. It is a model that’s been taken up pretty much everywhere, for centuries. But it is only any good if zero is a better cost of funding than just borrowing it in the wholesale market. Negative rates mean it is a worse cost of funding, so banks don’t work.

Huw van Steenis: Like steroids, unconventional policy can be highly effective in small dosages, but just as the long-term usage of steroids can weaken bones, so can below-zero rates weaken the financial system. So now, negative rates are creating challenges for banks, insurers and pension funds. But banks need to play the cards they are dealt. This means driving scale on platforms to offset low rates, margin compression and technology investments will be an enduring theme. For most banks, this will involve fighting it out for market share and adding adjacent services through platforms. But don’t rule out some banks looking to deals to drive scale, especially if the environment were to deteriorate.

Sam Theodore: The elephant in the room is the stubbornly high ‘analogue’ excess capacity [of the European banking sector] – not Basel IV, not the European Central Bank’s negative rates and not the lack of pan-European deposit insurance. Mobile-embracing customer behaviour and competition from fintechs and Big Tech, spurred on by open banking regulations, make banks’ massive legacy infrastructures – branches and back offices – both costly and unnecessary. There is no way back on this path and banks will be increasingly forced to switch from walking to running on it.

With revenues under ongoing negative pressure, banks will no longer be able to keep kicking the excess capacity can down the road. More substantial legacy cutting will have to take place: fewer banks, fewer branches and smaller back offices. There were approximately 174,000 bank branches across the EU (including the UK) in 2018. It is likely that by the end of 2020 that number will fall to between 140,000 and 145,000, with more drastic cuts afterwards.

Q: Do you expect consolidation among European banks to increase in 2020? Will this be domestic or cross-border? What will be the drivers?

Mr Barua: There is definitely a case for consolidation among European banks given the struggle with low returns on one hand and the case for scale economics on the other. Increasing demands on investments in technology enhances the case for scale. Six-thousand banks is a bit too many for the continent, especially for an industry labelled as a utility now. Conditions are also ripe for mergers and acquisitions, given the broad dispersion of capital, economics and valuation between banks. Having said that, cross-border consolidation would need to be catalysed through fundamental changes in the regulatory landscape, especially with regards to deposit fungibility. 

Mr Brosens: An important way to deal with declining interest income is cost reduction. Taking advantage of economies of scale is an obvious way to trim costs, especially as markets are turning digital. Given that Europe’s banking markets are already overcrowded, consolidation is one of the few options available to increase scale for individual banks. Domestic consolidation is ongoing, but cross-border consolidation continues to be difficult because a single European banking market still does not exist. Regulations and their application differ per country, and countries continue to impose local capital and liquidity constraints. This makes it more difficult to run a European bank as a truly single, consolidated entity.

Mr Ryan: You need banking union for cross-border consolidation. There is no point consolidating parent companies unless you can merge the balance sheets. Today you can’t, so being bigger doesn’t bring scale benefits. In fact, under the Basel rules, you might well find your capital requirements rise, so it is value destructive. In-market deals are a problem, because most markets are internally consolidated, or have a lot of co-operative and state operators. The Netherlands doesn’t need consolidation; Germany can’t have it.

Mr Theodore: The main consolidation process likely to intensify in 2020 is in-market among second-tier banks, mainly in Germany (within the co-operative and savings groups) and Italy. While the large banking groups have the capacity to meet digital challenges – some better than others – the smaller and less diversified banks do not. It is unrealistic to hope that, on its own, a branch-based traditional retail bank with a narrow range of products can remain economically viable by migrating to the digital ecosystem.

But in-market consolidation will inherently remain a painful process. Local social and political hurdles related to ownership, legal status, business missions and funding stand in the way of successful consolidation. There is also the issue of top management and board teams with a short-term vision on the future, unwilling to embark on a strategy that may not favour them personally during their tenure.

As for cross-border bank mergers, they don’t look like a realistic route in the digital age. Large cross-border mergers, including in the euro area, would do more harm than good, unnecessarily postponing digital transformation while spending precious years on a forward-to-the-past integration process of the two legacy banks. While in the meantime these banks’ competitors could jump the queue in the digital space through open banking-as-a-service platforms and partnerships. 

Q: What is the biggest regulatory issue facing European banks in 2020? How should banks deal with it?

Mr Barua: Most banks in Europe are over the regulatory hump, especially with capital and liquidity levels significantly stronger since the lows of the global financial crisis. Having said that, there is still a long tail of regulations under Basel III (popularly known as Basel IV) that are still being introduced and are likely to be applied over the next few years. But the risks from these regulations have been well quantified and signposted; they’re unlikely to be a shock to the system, especially given the ample lead time to their implementation. 

Mr Brosens: The regulatory and supervisory framework for banks continues to evolve rapidly, just think of Basel 3.5, the implementation of the revised PSD2, the build-up of ‘bail-inable’ liabilities and the Interbank Offered Rate transition, to name a few. But what probably continues to be really top of mind at many banks is getting customer due diligence right. While it is clear that banks have more homework to do, a consensus is emerging that they can’t do it alone. Closer co-operation with authorities and across borders is needed. The establishment of an anti-money laundering authority at EU level, alluded to by the European Council in December, would be a logical step forward.

Mr Ryan: We might just be seeing the end of the regulatory cycle. That is important, as without a stable rulebook you can’t allocate capital. There are still banks, for example in Spain, with capital ratios that are low; or of course, in Greece, where problem assets are still the thing. But it is finally stabilising.

Mr van Steenis: The year 2020 may be when the climate risk analysis of portfolios moves out of its niche and into the mainstream. Investors and boards have begun to realise that it can be more costly to ignore these issues than to try to grapple with them.

A flurry of central banks are introducing climate stress tests for banks and insurers, following the lead of Bank of England governor Mark Carney. The insights these tests provide could be used by boards and investors to change practices in asset allocation and risk management.

The scenarios and tools that are developed are likely to spread into the investment world too. Tests designed by Australian policy-makers, in fact, will explicitly cover pension funds, not just banks and insurers. Better metrics, which may become mandatory, investor activism and the growing realisation of large valuation dispersions will reinforce this.

Mr Theodore: The implementation of the EU’s revised PSD2 will likely be the biggest regulatory challenge for banks in Europe. Prudential regulations, which have been piling up in the post-crisis decade, have forced the banks to adapt, but also have in a way protected the industry from non-bank competition.

On the contrary, PSD2 opens the gates to non-bank participants in financial services, such as fintechs and Big Tech (although the latter is more harshly scrutinised by regulators and policy-makers). Banks will be forced to set up open application programming interfaces with financial information for their clients (with the clients’ prior agreement) and third party-providers, such as fintechs or even other banks that will be able to compete with their products for these clients.

Open banking is a new ecosystem for the banking industry, one with which many banks are plainly not comfortable. It is not at all evident that many European banks will be able to adjust to open banking. The main threat is for second-tier European banks outside the Nordic area, where all banks are digitally well advanced.

Q: Which is the bigger threat to European banks: competition from fintechs and challengers or from Big Tech?

Mr Barua: As McKinsey wrote in its recent Global Banking Annual Review, banking is being clearly disrupted by both fintechs and Big Tech. Nowhere is the evidence clearer than in operating models, where neobanks operate at less than half the cost base of larger banks and with much better customer service. Most disruption has been seen around non-balance sheet-driven plays, such as payments and foreign exchange, and so on. The jury is still out on the appetite of Big Tech to participate in pools that are highly regulated and credit risk driven. Irrespective of where the threat comes from, it is all change in the way banks operate, as value gets transferred from the industry to the end customer aided by the role of technology.

Mr Brosens: Fintech start-ups are not only challengers, but also natural partners for banks. They tend to focus on doing one thing really well and outsourcing the rest. They also often lack a large client base, a well-known and trusted brand, and the funds to make the necessary investments to scale up. Partnering with banks can be beneficial for both parties. Technology giants do have well-known brands, a large client base and can outspend banks on research and development. They’re more of a threat. At the same time, recent partnership announcements show that Big Tech has – for now at least – no intention of acquiring banking licences. They’d rather outsource the difficult business of regulatory compliance to the experts: banks.

Mr Ryan: The real risk is regulatory arbitrage. It is expensive being a bank. If it is possible to have your customers consider you a bank, without you having to hold all the capital, liquidity and so on that a bank does, it’ll be very profitable. I’d worry that, in the UK as an example, people think that ‘current accounts’ are bank accounts. Not any more they aren’t: non-banks can offer them.

Mr van Steenis: The best way to look at any business is from the standpoint of the clients, as I tried to in the ‘Leading the Future of Finance’ report for the Bank of England. On the whole, the innovation and competition in payments, investments and banking is driving better value for clients. So, we should welcome this. But given the pace of change, firms should be somewhat paranoid and keep an open mind to be at the forefront of monetising data, improving the client offering and leveraging a modern toolkit anchored around machine learning, cloud and processing automation.

Mr Theodore: In fact, the main threat is the banks’ own inability to adapt to the new digital ecosystem. Neither fintechs nor Big Tech are direct threats per se. Most fintechs are not profitable yet; they need to reach critical mass. The more they grow and diversify, the more supervisors will lean on them over prudential and conduct issues. Some neobanks will sprint ahead and eventually become profitable. But most of them will need to work closely with the incumbent banks and piggy-back onto their infrastuctures (for compliance, for example). Ideally, the fintech-to-bank relationship will be symbiotic, not adversarial.

As for technology giants, they’re not interested in displacing incumbent banks and they don’t wish to become regulated banks themselves. Closer relationships have started in the US (for example, between Amazon and Apple with JPMorgan and Goldman Sachs). Similar developments could happen in Europe, although the regulatory acceptance of Big Tech in finance is likely to be more restrictive. Facebook’s Libra is a case in point.

In general, banks are in a more solid position in Europe because of the higher degree of financial inclusion existing already – a very low percentage of unbanked or underbanked population – in contrast to regions such as Asia, Africa or Latin America – or even the US, where about 33 million households are unbanked or underbanked. The lower the level of financial inclusion by incumbent banks, the higher the likelihood that new players such as fintechs and Big Tech will make good market inroads into banks’ territory.