After the Covid storm passes and European banks begin to assess the damage caused from shutdowns and an increasing number of non-performing loans, global consultancy Bain & Company says each each institution now faces a classic choice, whether to use a crisis as a catalyst to remake their business and return to growth, or stick with their current model in the vain hope of inertial recovery, and possibly fade into irrelevance.
Bain told NextMoney that economic crises have always been moments that reshape entire industries. After the last financial crisis, top-quartile banks, as measured by earnings before taxes, outgrew the bottom quartile by 9 percentage points each year of the past decade,
“As European economies emerge from the economic turmoil caused by Covid-19, we believe that banks have a unique opportunity to take action to ensure future profitable growth,” said Roberto Frazzitta, a partner at Bain in Milan and the global leader of banking within the firm’s Financial Services practice. “European banks face the looming challenge of an increase in bad loans, but they also need to think beyond that, accelerating digitalization and ensuring that sustainability becomes truly core to their business.”
Bain projects that the flow of new nonperforming loans across Europe will total between €0.9 trillion and €1.2 trillion, 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 said Bain. 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 loan-loss provisions already put in place. Each cluster will require a tailored program to deal with the bad loans within.
Beyond that immediate issue, European banks have to contend with deep-seated concerns. They’ve suffered for years from a low return on equity— around 5% both in the European Union (EU) and the UK in 2019, well below the average cost of equity. ROE dropped further in 2020. The cost-income ratio, meanwhile, has been stuck at around 66% on average.
Behind these numbers lie several problems. First, there’s a wide digital gap between young neobanks and traditional banks, which limits the latter’s performance in cost, speed and the customer experience. Second, profitability has evaporated in traditional revenue pools, such as commercial loans over €250,000.
Bain believes that to deal with these structural concerns, once banks develop a solid plan for nonperforming loans, they should turn their attention to five broader actions.
Accelerate digitalization. All traditional banks have launched digital initiatives. But with customers increasingly buying financial services products from fintechs and large technology companies, it’s 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 long-term, sustainable 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%.”
Two functions deserve special attention. With work likely to occur at both home and office locations, banks should rethink their use of real estate, to eliminate nonfunctional spaces and optimize 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, then, is an essential prelude to making the most of opportunities that emerge from the recovery.
Turn sustainability into a business proposition. Increasingly, elements of sustainability are figuring as key components of growth in banking. Products and advice related to such issues as decarbonization 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 only up to 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,” said Dirk Vater, a Bain partner based in Frankfurt and the head of the Financial Services practice in EMEA. “Banks that deal now with the key challenges and opportunities stand a far better chance of thriving during post-pandemic years and building a durable competitive advantage no matter what new challenges emerge.”
The Bain & Company analysis of Capital IQ data featured in a new report For European Banks, Time to Set a New Course After the Storm.