IS THERE ANY more miserable spectacle in global business than that of Europe’s lenders? A decade after the crisis they are stumbling around in a fog of bad performance, defeatism and complacency. European bank shares have sunk by 22% in the past 12 months. Deutsche Bank and Commerzbank are conducting merger talks with all the skill and clarity of purpose of Britain’s Brexit negotiators. Two Nordic lenders, Danske Bank and Swedbank, are embroiled in a giant money-laundering scandal. The industry makes a puny return on equity of 6.5% and investors think it is worth less than its liquidation value. Amazingly, many European banks and regulators are resigned to this state of affairs. In fact it is a danger to investors and to Europe’s faltering economy.
The banks make two excuses, both of which are largely rubbish. One is that it is not their fault. Unlike America, where banks have a return on equity of 12%, Europe does not have strongly positive government-bond yields, or a pool of investment-banking profits like that on Wall Street, or a vast, integrated home market. All this is true, but European banks have been lamentably slow at cutting their costs, something which is well within their control. As a rough rule of thumb, efficient banks report cost-to-income ratios below 50%. Yet almost three-quarters of European lenders have ratios above 60%. Redundant property, inefficient technology and bloated executive perks are the order of the day.
The banks’ second excuse is that their lousy profitability does not really matter. Their capital buffers have been boosted, they argue, so why should regulators and taxpayers care about the bottom line? And shareholders, the banks hint, have learned to live with the idea that European lenders are unable to make a return of 10%, the hurdle rate investors demand from American banks and most other sectors (see article).
This is bunkum, too. Profits do matter. They make banks safer: they can be used to absorb bad-debt costs or rebuild capital buffers when recession strikes. Depressed valuations show that far from tolerating European banks, most investors eschew them. As a result many lenders, including Deutsche, have too few blue-chip long-term institutional shareholders who are prepared to hold serially incompetent managers to account. And when the next downturn comes and banks need to raise capital, which investor would be foolish enough to give even more money to firms that do not regard allocating resources profitably as one of their responsibilities?
Rather than accept this miserable situation, European banks need to do two things. First, embrace an efficiency and digitisation drive. Costs are falling at an annual rate of about 4%, according to analysts at UBS. This is not enough. As consumers switch to banking on their phones there are big opportunities to cut legacy IT spending and back-office and branch expenses. Lloyds, in Britain, has cut its cost-income ratio to 49% and expects to get to close to 40% by 2020. The digital German arm of ING, a Dutch bank, boasts a return on equity of over 20% in a country that is supposedly a bankers’ graveyard. If other banks do not do this they will soon find that they have lost market share to new digital finance and payments competitors—both fintech firms and the Silicon Valley giants such as Amazon—that can operate with a fraction of their costs and which treat customers better.
Second, banks need to push for consolidation. The evidence from America and Asia suggests that scale is becoming a bigger advantage in banking than ever before, allowing the huge investments in technology platforms and data-analysis to take place. Europe has too many lenders—48 firms are considered important enough to be subject to regular “stress tests”. The banks complain that the reason for this is that Europe has not harmonised its rules and regulations. But this is only half the story. Most big banks are loth to cede their independence, and their bosses love the status that comes with running a big lender. And banks’ failure to get their own houses in order means that investors doubt that managers can handle integrating two big firms.
European banks face two paths. The one they are on promises financial and economic instability when the next recession strikes, and long-term decline. The other path is to get fit for the digital age and subject themselves to the financial disciplines that American banks, and almost all other industries, accept as a fact of life. It should not be a hard decision.
