Europe’s banking sector faces challenge of increasing profit levels

Falling profit levels is currently a common concern in European banks, whose performance in terms of ROE in recent years has almost halved, while their evolution is particularly worrying when compared to that of US and Asian banks (See figure above). According to the report, profit levels should start to improve when the finance sector tackles major challenges, such as changing consumer behavior, technological advances, persistently low interest rates, and pressure from new regulations.

The report is based on the opinions of banks on which new regulations are having a negative impact on business in two main areas. The first of these is the burden of work that comes with new regulations. Some new laws mean major changes in the structure and organization of banks. The second derives from the rising capital requirements, which, according to the estimations of the European Banking Federation, have increased threefold following the application of the pertinent new directive and regulation. Moreover everything points to there being a greater demand for capital for European banks in 2016.

The report also considers that the Banking Union has made considerable progress given the speed, complexity and depth of reform. However, it states that there is still work to do if we want the Banking Union to meet its three main objectives, namely to break the vicious circle that links banks with sovereign risk, prevent taxpayers from having to foot the bill for another banking crisis, and normalize credit flows to businesses and homes. The report states that three key tasks remain:

1.      Create truly homogenous and consistent legislation.  The sole regulatory code that European banking institutions should follow to enable across-the-board compliance with the criteria of Basel III is an essential step in the right direction, but there is still room for discretional deviation from said criteria on a national level. The Single Supervisory Mechanism has identified 150 specific cases in which states have the capacity to tinker with or alter national legislation.

2.      Coordinate decision hubs based in Frankfurt and Brussels. The separation of the tasks of supervision and resolution plays a pivotal role in the structure of the Banking Union. The existence of two different mechanisms - the MUS, based in Frankfurt and the MUR, based in Brussels – ensures that criteria will be independent and guarantees effectiveness.  This model must, however, be highly coordinated, because part of the work of both institutions forms part of a shared mechanism.

3.      Complete the process. In order to complete the Banking Union process there are still some pending decisions, many of which are highly political. These decisions include the creation of a European Deposit Insurance Scheme, or a review of the European Stability Mechanism direct bank recapitalization instrument.

In addition to these three challenges, the report explores what needs to be done beyond the scope of the Banking Union in order to avoid discrimination between the formal banking system and the shadow banking system. The more the Banking Union’s new regulations, supervision, and resolution practices advance, the more apparent the discrimination between the formal banking system – subject to major restrictions – and the so-called shadow banking system becomes. The solution to this problem is complex and beyond the remit of the Banking Union, but acknowledging the systemic importance of shadow banking – with an estimated volume of 70 billion dollars – would be a first step in the right direction.

The  Banking Union, Onward and Upward Report explains that the Banking Union is crafting a regulatory and supervisory structure with many positive features in fields that include capital, security, stability, homogenous criteria, and good practices,  but it also recognizes that in view of the difficulties involved it is a highly complex undertaking, and a great deal of the financial and operative responsibility falls on the banks.

Note: PwC and IE Business School Financial Sector Center is a joint project which began in 2010 with the aim of creating an organism of reference for research in the field of finance and dissemination of all related aspects. This report examines the challenges facing banks in Spain and worldwide during the current transformation process. The Center is the only one of its kind in Spain and acts independently of banking entities