Understanding European Banks Today in Four Simple Steps

Not a single week passes without Deutsche Bank being discussed in the news. Most recently, numbers were leaked that the biggest German bank is supposed to pay $14bn in fines. Although the actual negotiated fine might be much lower, on 30^th September, Deutsche Bank shares dropped under 10 Euros, reaching another record low. Commerzbank, too, is struggling with its current business model, announcing that it would cut nearly 10.000 jobs and halt paying dividends. Similar to the big banks, smaller banks also are reassessing their business model and searching for ways to become more profitable. Findings by the International Monetary Fund support the current problematic situation. One-third of European banks, which account for roughly $8.5 trillion in assets, are found to be weak and struggle with low profitability.

Understanding the problem with EU Banks in four simple steps.

Step 1: How do Banks make Money?

The two most important sources of income for banks are the spread and fee businesses. A bank takes a customer’s deposits and pays in return annual interest. Some of these deposits are then loaned to other customers who take out credit for personal consumption or other financing activities. The difference between the two interest rates is effectively the profit margin for banks and represents the spread business of a bank. A bank pays a lower interest to customers who deposit their money and charges a higher interest from customers who take out a loan. Secondly, a bank generates income from account-related charges, the so-called fee business. Service fees or overdraft fees are some common examples of such charges.

Step 2: Understanding Low Interest Rates and Basel III

The European Central Bank has kept its interest rate on hold at zero, while charging commercial banks minus 0.4% on deposits. This puts a lot of pressure on the banks’ profit margins, while future regulations increase costs and thus cut profits even further. The most discussed regulation is Basel III which was developed by the Basel Committee on Banking Supervision in response to the global financial crisis with the objective of promoting stability in the international financial system. Under Basel III banks must hold more capital against their assets which leads to a decrease in their balance sheets and hence restricts a bank’s ability to leverage itself. Until 2019 banks must change their capital structures to have a minimum equity requirement of 7%. Given the current situation banks either try to cut costs or look at the fee business to offset higher costs and capital requirements. Nevertheless, the fee business, too, is under pressure since banks have offered free banking without any charges for quite some time. Because of lower profit margins and higher costs due to new regulations, banks demand an increase in interest rates and a break from further regulation to be able to deal with the current situation and transform their current business models. In comparison, American Banks recovered from the financial crisis more quickly and are more profitable since they were able to deal with the non-performing loan problem in a more efficient way and the economy in the US returned to a growth path quicker than the one in Europe. While the ECB is expected to continue its low interest rate policy, the Federal Reserve is already discussing an increase in interest rates.

Step 3: Assessing whether European banks are really in trouble?

In its latest assessment of global financial stability, the IMF found that European banks need “urgent and comprehensive action” to deal with legacy non-performing loans and inefficient business models. Not taking any action will make it hard for European banks to earn enough profits to stay viable and support economic growth. Not only are European banks dealing with some 900 billion euros in bad debt ($1.01 trillion) left over from the last financial crisis, but weak profitability, low-interest-rates and a low-growth environment are also negative factors that will erode European banks’ buffers over time. Consequently, this will limit European banks in their ability to support an economic recovery and will limit overall financial stability. Peter Dattels, deputy director of the IMF’s Monetary and Capital Markets Department, states that many European banks have too many branches which collect too few deposits, while having higher costs than their U.S. rivals.

Step 4: Suggestions to solve the problem

To solve these problems, the IMF’s stability report recommends European regulators and policymakers strengthen insolvency regimes by allowing banks to foreclose on legacy non-performing loans more quickly. Secondly, the report recommends consolidating weaker banks into stronger ones and reducing overall costs by adopting a more sustainable business model. Solving the problem of a big overcapacity of banks and addressing the problem of low returns, while also implementing regulatory changes that boost confidence without a massive increase in capital requirements, could potentially boost profitability of European banks by $40 billion annually, according to calculations of the IMF. In combination with a cyclical recovery, the share of “healthy” European banks could increase to 72% compared to 17% last year.