Lecture on bank’s profitability 16.10.2024

Claudia M. Buch, Chair of the Supervisory Board at the European Central Bank

“Bank profitability a mirror of the past, creating a vision for the future”

On the 16th of October the class of MCF 25 had the remarkable opportunity to meet Mrs. Buch, who is currently on the supervisory board of the European Central Bank. Her lecture on the profitability of banks in the past, today and in the future shed light on the cruciality of long-term sustainability of profits and the need for banks to keep up with trends especially concerning digitalization. 

The global financial crisis has revealed that short-term profit optimization, resulting in high profitability, such as in the years before 2008, can in fact mask possible underlying challenges and come at the expense of long-term resilience and incentivize risk-taking. In order to prevent crises of this kind the ECB has introduced resolution regiments, regulatory reforms and equity capital requirements like Basel III.

While the European banking system has demonstrated a rise in profitability in the last 5 years, due to a boost in market power and introductions of advanced business models. Higher interest rates have pushed up net interest rate margins in the last few years by more than 1.6 percent. Still, the pass through of higher interest rates to deposits has varied significantly across countries, stemming from differences in lending conditions (fixed vs. variable rate lending). The overall pleasing levels should now be utilized as a window of opportunity for banks to invest in their vision for the future, strengthen sustainable profitability and enhance business models. In order to steer banks into stability, the supervisory mechanisms of the ECM focus on long-term lucrativeness, viable business models, solid governance and thorough scenario analysis.

One of the main drivers of future long-term sustainability is going to be further digitalization to keep up in the world of digital finance. Gathering long-term capital to invest in the needed infrastructure is and will be a critical task for banks. (Currently, US banks surpass European banks in terms of IT-investments.) To guide banks on their path to keep up with technological trends, the role of the ECB is also evolving. To supervise effectively, the focus is set on long-term and forward-looking capital management which includes the banks to build a three-year range capital commitment, cyber resilience, IT investments, and compliance within the outsourcing chain, as well as governance/risk management and establishing accountability of individuals within the bank. All in all, from Mrs. Buch's talk one can take away that there is a clear need for banks to align their strategies with these evolving supervisory expectations to ensure they remain competitive, resilient, and well-positioned for sustainable growth in an increasingly digitized financial landscape.

Brunella Bruno, Researcher with Tenure at Bocconi University

“In bold for the moment to better view the structure”

The COVID-19 crisis has had a direct positive impact on the profitability of European banks. The restrictive monetary policies of the ECB implemented to limit wild inflation, such as interest rate hikes, have benefited financial institutions. Nonetheless, differences in banks' size and business model reactions to these macroeconomic events have impacted Financial Institutions' ROE figures differently, showing high dispersion across the industry. Among other drivers of profitability, there has been a notable increase in net interest margins (NIM) due to an ongoing widening loan-deposits trend that started in 2020. Also, Cost-to-Income has drastically improved, even if only because of an increased figure of Operating Income in the denominator and not of a reduction in Operating cost in the numerator, thus indicating an upward trend since 2020 that testifies to higher operational efficiency. Also, a decreased figure for the Cost of Credit/Risk, due to the positive effect of the anti-inflationary measure taken by the ECB together with a more stringent policy on Loan Loss Provisioning on the banks, has avoided the default of some debtholders, so improving portfolios health and decreasing the credit risk. However, there have been early signs of deterioration in the past two years of asset quality. Eventually, the bank’s profitability trend in Europe is strongly driven by the favorable interest rate scenario, even though there have been some signs of increased loan loss provisions from banks that can indicate a possible future economic downturn.

Filippo De Marco, Associate Prof. of Finance at Bocconi University

Only since the emergence of the global financial crisis of 2008 it has been possible to first identify the direct correlation between increasing bank stock returns and interest rates, backed by a 3.97% rate for the end of 2023. Banks' strategy to keep low interest rates on deposits has not only ensured higher profitability but has also been beneficial for keeping up with competition and high regulation in the European banking industry. Another reason can be found in the bank’s remarkable ability to re-invest well with cash inflow that comes from a larger deposit base. Banks can dare maintain the same level of profitability even though they are maintaining low rates because of the high bargaining power of suppliers of loans and of the high financial illiteracy of the average “sleepy” investor that provides deposits to it. In the era of digitalization of banking services, not only is easier to provide loans and receive deposits, but it is also needed to strategize the business model to keep up with the competition; In this regard, High-rate banks primarily operating online can attract fewer loyal depositors while Low-rate banks operating large networks can attract stickier ones. In connection with ECB Supervisor Claudia Bach, supervision of financial institution activities also includes anti-cyclical measures designed to mitigate the impact of adverse economic cycles on the financial system. Among these tools, we have Countercyclical capital buffers, set by national (and non-national) authorities to oblige banks to allocate more equity against their Risk-Weighted Assets, and Dynamic Provisioning of Expected credit losses, which take place in good times based on expected adverse future times impact on profitability. 

SDA Bocconi School of Management