Ángel Monzón interview with Bankovnictví: Profitability of the banking sector peaks

Profitability of the banking sector peaks

Claims the Head of Risk Analysis and Stress Testing at the European Banking Authority (EBA) Ángel Monzón. According to Monzón, falling interest rates will influence the banking sector’s profitability the most in the coming period.

But to what extent have higher rates affected non-performing loans? How does banking differ from region to region? And what will the EBA focus on in the coming period? We discussed these topics and many others with Ángel Monzón.

According to the results of the latest stress test conducted in 2023, European banks seem to be resilient. Has anything changed? What impact is a period of high interest rates and a slowing economy having on the whole banking sector?

The stress tests actually showed that banks are resilient to key challenges, such as worsening asset quality. On average, banks also have high capital and liquidity levels. 

In addition, the increase in interest rates in recent years has had a positive impact on banks’ profitability, mainly thanks to their net interest income as a consequence of expanding net interest margins. An important aspect that appeared because of low economic activity was the potential negative impact on asset quality. Until now, however, the impact on the costs of risk and non-performing loans (NPLs) and on stage 2 indicators has been dampened or low, mostly concentrated in certain segments or sectors. The commercial real estate (CRE) segment is an example of the increase in credit risk.

If I’m not mistaken, the EBA is already preparing stress tests for 2025. Will anything be different compared to the tests in 2023? What main factors will change?

We have just published the stress testing methodology for consultation with banks. It is true that this year we have included several changes in the methodology. One of the natural changes is the implementation of the revised Capital Requirements Regulation (CRR3), seen as stress testing adheres to the current regulation. Another aspect is banks’ exposures to business sectors. We asked for this information in the previous stress test, because we think it is very important for banks to be able to provide projections differentiated by the sectors to which they are exposed. This time, we indicated that banks should continue to improve their sector models by setting clear expectations regarding acceptable approaches to projections. We also made several changes in the area of market risk, in order to achieve a more sensitive methodology. Finally, without being too technical, we made some changes leading to a more centralised approach to net interest income and provided banks with projections for some portfolios.

We have just published the stress testing methodology for consultation with banks. It is true that this year we have included several changes in the methodology. One of the natural changes is the implementation of the revised Capital Requirements Regulation (CRR3), seen as stress testing adheres to the current regulation.

What risks do banks face today?

The risks are various, one of them is the uncertain outlook for economic growth together with high geopolitical risks. This could, for example, lead to an increase in losses from credit risk. Central banks have started to reduce interest rates in some countries, which could have an impact on bank profitability, because net interest income is one of the main contributors to bank profitability. Our indications are that profitability has already peaked, but is not yet declining. Another area of risk is cyber risk and the possibility of successful cyberattacks. This shows the need for banks to invest in digitalisation, which will enable them to increase efficiency, strengthen their competitive advantage and further increase their resilience.

Do risks differ in different countries and regions? For example, south vs north?

In general, I would say that the key risks are common for the whole banking sector throughout Europe. Macroeconomic uncertainty, partly caused by geopolitical risks, as well as rising credit risks as a consequence of higher interest rates and low economic growth, are more or less common topics throughout Europe However, the risks for individual banks mainly differ depending on the structure of their assets and liabilities, rather than where a bank is located. Banks with a high share of assets with floating interest rate loans may have a higher credit risk than banks where most debtors are protected from higher interest rates thanks to fixed interest rates.

Depending on each country’s economic cycle, banks may be confronted with various risks. For example, banks in southern European countries (mainly Italian and Greek banks) had to deal with a large amount of non-performing loans from the crises ten years ago. It required a lot of effort to get rid of the debts and several years’ work before they cleaned their balance sheets of non-performing loans.

Another example is the type of exposures that banks have on their balance sheets. For example, in several jurisdictions there have been problems related to trends in the commercial property market. Although the correction on the commercial property market is a more general problem, particularly in the office sector, some jurisdictions are more influenced by this than others across Europe. This may have an impact on the asset quality of specific banks that are exposed to such markets.

Operational risk is another crucial challenge for banks. It may be general across the whole EU, but some jurisdictions may be more and more vulnerable to such attacks. For example, cyberattacks, which may be linked – to a certain extent – to geopolitical risks, may target banks or debtors in specific jurisdictions.

NPLs (non-performing loans) of European banks are above 1.8 %. Is there a risk they will increase?

First of all, I would like to say that this coefficient is at a very low level, in particular in comparison with the past. Since the global financial and government debt crisis, significant efforts have been made by banks, supervisory authorities and politicians to deal with this problem effectively. In the first quarter of 2024, NPLs of around EUR 360 bn were reported, which is a large fall in comparison with more than EUR 1 tn ten years ago. Nevertheless, it seems that the downward trend in this coefficient has reached its end, and banks are already reporting a certain increase in these numbers. We expected this to happen because of the rise in interest rates and subdued economic growth.

To a certain extent, this growth was more limited than originally expected. In fact, we have seen a certain worsening of asset quality, in particular in exposures to commercial property, small and medium enterprises and unsecured retail loans. In the middle of high economic uncertainty and geopolitical risks, this worsening may continue. Nevertheless, it should be said that we are starting from low levels of NPLs and – as already mentioned – banks are reporting high capital and liquidity.

How much do high interest rates influence banks’ income?

As I already said, net interest income is a crucial factor in bank profitability and it traditionally rises at times when interest rates are rising and falls when rates are falling. In the future, we can therefore expect that the growth in net interest rate margins will halt. This is something that we covered in our recently published risk assessment report. Net interest income in the EU rose in the first half of 2023, but then remained stable in the second half of 2023. This supports the idea that ROE could remain stable for the meanwhile. Nevertheless, reductions in central bank interest rates may have an impact on banks’ net interest income, which, unless banks are able to replace it with other sources of income such as fees, could lead to a fall in ROE.

When we talk about profitability, we can observe a regional disparity. Why is that? For example, Czech banks are more profitable, while banks in other countries are less so.

Czech banks were more profitable in comparison with the EU/EEA average, with a slightly higher return on equity (ROE). There are many parameters that influence profitability. For example, from the income viewpoint, the mix of assets and liabilities and whether products have fixed or variable interest rates play a role. In the case of Czech banks, net interest income plays a larger role in the income mix than the average of their EU/EEA peers.
Another aspect is banks’ ability to manage their costs. Czech banks, for example, have a lower cost-to-income ratio, i.e. they have lower costs to generate their income in relative terms (almost 50 % for Czech banks vs almost 55 % for the EU/EEA average). This shows how successfully banks are able to manage their spending on staff, their branch network and IT. However, this is also a challenge, naturally – too high a saving on IT, for example, can mean a higher risk of IT failure, cyberattacks or similar undesirable events.

Another factor is risk costs, i.e. the cost of impaired loans, to put it simply. This parameter is also more favourable for Czech banks in comparison with their EU/EEA peers (0.2 % vs. 0.6 %). If banks successfully manage their credit risk during all economic cycles, this can also help support profitability.

ESG is a big topic, in particular sustainability. However, the risk of greenwashing, which can very easily occur, is very strongly linked to it. The EBA has also published guidelines on greenwashing. Will greenwashing really be such a big risk? And what can banks do to avoid unintentional greenwashing?

Yes, the EBA published a Greenwashing Report in June, which was our response to the Commission’s request for advice. In the report, we point out that the increase in alleged cases of greenwashing over the last decade was significant – globally 7.3 times higher in 2023 than in 2012 in all sectors and 21 % higher in 2023 compared to 2022.

Greenwashing can actually have an unfavourable impact on institutions’ financial risks - mainly on reputational and operational risks, including litigation risk. As greenwashing can be committed unintentionally, banks have to be careful about their communications concerning sustainability, to ensure that they are objective, clear and not misleading. Banks must also take the risk of greenwashing into account in their risk management policies and procedures, conduct proper due diligence assessments of projects and counterparties that they finance and review and adapt their management structures and internal processes to build in safeguards against greenwashing.

From the start of next year, banks will have to comply with the DORA requirements. How big a challenge will it be for European banks?

Management of the risks of information and communication technology (ICT) should not be anything new to banks, because it is part of the framework that banks have had to comply with for more than ten years. DORA came into force in January 2023, so banks have had the chance to familiarise themselves with it before it comes into force at the start of the next year. However, DORA increases and harmonises the requirements for ICT risk. First, banks will have to adapt their risk management processes to the new requirements, as well as the classification and reporting of incidents related to ICT and cyber threats. Second, they will need to have established effective third-party risk management, including monitoring of ICT services provided by third parties that support critical or important functions. Finally, they will need to ensure suitable programmes to test the resilience of their digital services.

When we are talking about technology, it is necessary to mention the forthcoming digital euro project. According to some experts, this may influence European banking. What is your opinion? How do you see the connection between banking and cryptocurrencies in general?

Projects related to the introduction of central bank digital currencies (CBDCs) for retail have obtained momentum inside and outside the euro area. The introduction of CBDCs such as the digital euro may also have an impact on banks and the specific impact will depend on many aspects related to the design of the CBDCs. For example, CBDCs may lead to a certain outflow of domestic deposits, as households can transfer part of their deposits to CBDCs. This may have an impact on bank profitability due to the replacement of financing by client deposits with more expensive sources of finance. Fee income may also be influenced, as may operating costs and operational risks. Nevertheless, it should be emphasised that CBDCs will also have positive impacts for banks, for example in the sense of new income streams from products and services related to CBDCs. There may also be positive impacts on operational risks, for example as a result of a smaller number of cash withdrawals or replacement of outdated systems and processes with new technology.

As far as concerns cryptocurrencies, there are certainly links to the banking sector, including potentially increased operational risks and financial stability risks if the size of crypto asset markets and their interconnectedness with traditional financial markets increases. Nevertheless, these links are still estimated to be rather limited. At the current time, banks do not see crypto assets as a key product that they should offer, even though the situation may change now that the MiCAR regulation is coming into force.

AI is also a hotly debated topic. How big a change can AI entail for the banking sector? Can AI be a driving force behind banking profits, if we take into consideration that it can perform many tasks more cheaply than humans?

The use of AI in itself is nothing new for the banking sector. Nevertheless, thanks to access to exponentially larger datasets, improvements in algorithms, migration to the cloud and increased computational capabilities from specialist third-party providers, AI has become an integral part of banks’ data analysis and predictive abilities, and the complexity of AI techniques used is increasing with incredible speed. We recently entered the era of general AI, with a significant number of European banks already testing or experimenting with general AI. Banks regard this as a very serious opportunity thanks to its potential to generate large gains in operational efficiency and risk management capabilities.

The use of increasingly advanced AI, however, brings important challenges for banks, supervisors, consumers and investors. The complexity of advanced AI systems increases fears about explainability and transparency, further strengthens banks’ dependence on third parties in the field of operational resilience, and the need for big data increases existing fears about privacy, data security and data management. Banks may also encounter problems in competing in AI with non-financial corporations, in particular in terms of access to the necessary expertise and skills. This can be especially difficult for smaller banks. Finally, the use of AI in banking raises important fears in the areas of supervision of prudential and financial stability. We are therefore of the opinion that human judgement must remain the core of risk management and administration in the banking sector.

One final question. What are the main topics that will animate the banking sector in 2024 and 2025 and that you are most interested in?

As I said earlier, there are several risks that banks are facing, but if I had to choose, I would say one is geopolitical risk with possible consequences such as fragmentation. Banks must assess how geopolitical risk can influence all their business areas. The other is the increased use of technology, which has many positive aspects, as was mentioned earlier, but banks must remain prepared for the impacts related to digital technology, such as cyberattacks, risks related to the use of artificial intelligence or an increase in technology-related fraud.

Net interest income is a crucial factor in bank profitability and it traditionally rises at times when interest rates are rising and falls when rates are falling. In the future, we can therefore expect that the growth in net interest rate margins will halt.

The interview was conducted by Tomáš Houdek

Časopis Bankovnictví (Czech Republic)