Which European banks are still innovative?

Guest comment: The future of banks

In the 2008 economic crisis, banks were a major part of the problem. In the current, more profound, Corona crisis, they have made a significant contribution to overcoming the macroeconomic problems by providing liquidity and integrating them into a large number of aid programs. A distinction must always be made between (more or less) short-term crisis aspects and long-term structural challenges. This applies to the levels of the world economy, the EU and specifically Austrian aspects.

In the past decade - as a reflection of the macroeconomic dynamics - there has been a massive shift in the global economic balance of size and power in the banking industry. Of the ten largest banks worldwide by market capitalization, four each in 2019 came from the USA and four from China. The largest bank in the Eurozone by market capitalization, BNP Paribas, was ranked 19th, and Deutsche Bank ranked 56th among the largest financial institutions.

In the long term, there are also considerable differences in the financing structures. A characteristic of China is the close connection between the role of banks and state investment and financial policy. In the USA, external financing of economic activity is mainly carried out via the capital markets, while in Europe it is via the banking sector. Market capitalization was 104 percent of GDP in the USA, 43 percent in the EU and 20 percent in Austria (as of 2015). The share of loans to the private sector was 55 percent in the US, 136 percent in the EU and 120 percent of GDP in Austria. The great importance of capital market financing in the USA also means that US banks, through their functions as investment banks, tend to benefit from a policy of long-term low interest rates, while such a policy represents a considerable challenge for European banks - at least when viewed in isolation. Accordingly, in investment banking, which is not always unproblematic in terms of the economy as a whole, the European banks have fallen further behind the US banks.

Overall, there is also a significantly lower profitability of the European banking sector, which in turn leads to lower share prices and significantly lower price / book ratios (ratio of capital market valuation to balance sheet valuation). However, there are also considerable differences within Europe. While Scandinavian banks typically have price / book ratios above 1 (Swedbank 1.33 in November 2020), this value is 0.38 for Deutsche Bank and 0.31 for UniCredit.

In the USA, in addition to the banks, the area of ​​"shadow banks" (hedge funds, money market funds, but also insurance companies) plays a significant role that is comparatively less controlled in terms of financing. They are now also of considerable importance in the eurozone. According to the latest ECB financial stability report, around 20 percent of the loans are already granted to companies in the "shadow banks" sector. This means a doubling within ten years.

The "Basel" model does not always have to be an advantage

What conclusions can be drawn? First of all, capital market financing can also be expected to become increasingly important for Europe. This is intensified by the long-term effects of the international "Basel" banking regulations, which are essentially influenced by the Anglo-Saxon model of capital market-based financing. From a macroeconomic risk perspective, this means more favorable risk diversification - with regard to European economic structures, however, the "Basel" model does not have to be consistently advantageous. The traditional house bank model of a long-term mutual trust relationship between bank and borrower can be of great and positive importance, especially for economies with a significant proportion of small and medium-sized enterprises. Europe's economic policy should therefore endeavor to ensure that these aspects of SME financing are given special attention in the context of the further development of international financial regulation.

In Europe, too, it will undoubtedly be a question of strengthening the role of the capital markets, which is the aim of the various measures of a European capital markets union. With regard to the banking union, clear successes have been achieved through the far advanced, uniform EU banking regulation and the creation of a uniform EU banking supervision within the framework of the ECB. The project of a uniform deposit insurance for the euro banks, which would make cross-border bank mergers much easier, is still open. At least feasible intermediate steps are becoming apparent here.

Furthermore, Europe's banking sector is very fragmented. With more than 5,000 financial institutions currently in the EU, there is undoubtedly overcapacity and the associated low profitability. The challenges of digitization in particular will force huge investments, many of which will be associated with mergers. Processes of this kind are already running in Europe at the national level in many cases, although they often represent a challenging management task. In contrast, transnational mergers have so far hardly been able to establish themselves despite the European banking union.

Challenges through
the corona pandemic

All global and European developments are of course also of importance for Austria's banking system. This also applies to the challenges facing the corona pandemic. The domestic banks were and are an essential part of the stabilization measures that help prevent the slump on both the supply and demand sides from developing into an escalating economic crisis. This is in particular through the provision of the necessary liquidity (especially for the SME sector), the handling of state guarantees and loan deferrals totaling 22 billion euros. It helps that Austria's banks are well equipped with a core capital ratio of around 15.5 percent.

However, anticipated future burdens already require a massive increase in risk provisions. In the first half of 2020, this led to a year-on-year decline in profits for the banking sector of 75 percent to 900 million euros - this amount roughly corresponds to the profit contribution of the Austrian subsidiary banks in Central, Eastern and Southeastern Europe. In general terms, the Austrian business was therefore generally unprofitable. The cost / income ratio, which was around 65 percent in the previous year for the entire area, rose to 72.3 percent in the second quarter of 2020. Of course, there were considerable differences between the individual banks.

There are different estimates of the future development of non-performing loans and bankruptcies. With the expiry of the various aid measures and especially the deferral measures, an increase in non-performing loans and insolvencies can be expected, even if the economy generally recovers. The banks must take this into account by appropriately allocating risk provisions, which is what happens in the majority of cases.

Secure crisis resistance through high equity ratios

In general, it is a matter of ensuring the banks' resistance to crises by means of appropriately high equity ratios. In the medium term, of course, a certain dilemma can arise here: In the interests of crisis resistance, Europe's supervisory authorities will immediately advocate the lowest possible profit distributions - in the medium term, of course, corporate dividend policies will also play a role in the provision of new capital via the stock markets in combination with price prospects. The unfavorable value / book ratios of the European banks reflect the difficult conditions for substantial external financing. With a view to long-term bank stability, the supervisory authorities are therefore faced with very sensitive balancing issues.

From the real economy perspective, it is of great importance in the normalization process after the crisis to keep the expected increase in bankruptcies within limits and to avoid healthy companies being carried away. The term "creative destruction", coined by the great Austrian economist Joseph Schumpeter and often cited in the current crisis, relates to structural developments and not to the effect of profound economic downturns. August Friedrich Hayek's concept of the "cleaning crisis" and the recommendation of non-intervention that follows from it, on the other hand, has always proven to exacerbate and prolong crises.

During the transition from crisis mode to normal operation - which will undoubtedly be necessary later - it is important to proceed very carefully and step by step. In addition, one must be aware that a long-term economic weakness for companies can result not only in liquidity problems, but above all equity problems. Here it will be necessary to develop innovative forms of equity injection. For the SME sector, this could take the form of public-private investment companies.

Thinning of the branch network and technology costs

In addition to the risk aspects, long-term changes in bank customer behavior and the corresponding cost effects are also important. The increased share of electronic business areas as a result of the pandemic will accelerate the thinning of the branch network and entail further massive costs of technological upgrading. In an international comparison, Austria still has a very dense branch network - on the other hand, problems with the regional supply of banking services are already increasing. According to a study by the National Bank, at the end of 2019 there were no longer any bank branches in 555 Austrian municipalities (27 percent of all municipalities); in 2000 there were 271.

The branch office problem is of course only part of the fundamental problem of high expenditure / income rates. Numerous measures are necessary to solve or at least mitigate it. An essential aspect would undoubtedly be accelerated consolidation in the Austrian banking sector. A solution to the traditional industry constellation of "predatory competition without displacement" is only possible through consolidation steps. In the future, these are no longer only to be expected within sectors, but also across sectors.

The money and credit economy is always a central and exciting area of ​​an economy. The combination of international developments and national requirements as well as economic, technological and socio-political influencing factors continuously ensure dynamism and new challenges. All actors in the business and economic sectors must grasp this as early as possible and not only react, but also help to shape it if possible. A generation change is currently taking place in the management positions of many banks in Europe, partly also in Austria - a great deal of responsibility is being passed on here.