Significant changes and challenges characterized 2022. The war in Ukraine put the world order to the test while tensions increased between the US and China, and the European economy did not recover to total health with the end of the coronavirus pandemic, as supply chain problems, the energy crisis, and inflation created new challenges for companies.
Nevertheless, the banking sector is largely stable. Due to the turnaround in interest rates by the European Central Bank (ECB), banks even slightly improved their earnings, proving more robust overall. With a stronger position, most banks can withstand the current crises. Further improvements in cost efficiency and return on equity play a major role. The trend of falling cost-income ratios (CIR) and higher return on equity (RoE) is continuing, and European banks are continuing to catch up to the global competition.
Since mid-2022, the ECB’s gradual key interest rate increases have boosted European banks’ interest margins. After years of low and zero interest rates, the interest rate business is once again proving to be a driver of profitability. At the same time, financial institutions face challenges because rising rates also increase the risk of loan defaults and financing costs while lending criteria have tightened. Rising refinancing costs are increasingly burdening banks on the cost side.
Despite the significant increase in interest income, banks must not abandon the path they have taken to optimize their costs and customer relationships. New technologies open up many opportunities but are still underutilized, especially on the cost side. Digitalization helps to make processes more efficient without sacrificing customer service. In addition, targeted IT investments in digital banking and customer orientation can make a big difference. The trend is moving in the right direction, but many banks are still acting too cautiously compared to the potential pace of innovation.
The topic of sustainability (ESG) took a back seat in 2022, given the political conflicts and economic crises. Yet the need for sustainability and long-term thinking pays off. ESG will be a business area in which focused banks can once again generate additional revenue: the need for financing for climate-friendly green tech solutions will continue to grow, and demand is increasing in private customer businesses.
The most important findings of our study:
Europe’s banks once again improve their cost efficiency and return on equity - but not as much as in the previous year
Despite the uncertain market situation following the start of the war in Ukraine and its consequences, European banks increased their cost efficiency in 2022. They benefited from the ECB’s rapid turnaround in interest rates, which resulted in higher margins in the interest business. Overall, banks increased their interest income significantly, which was also the main driver that enabled them to increase their cost efficiency compared to the previous year. The average cost-income ratio (CIR) of European banks improved to 58.7%. In 2021, it was almost 3 percentage points higher. In 2022, European banks managed to increase their return on equity (RoE) by a further 0.2 percentage points to 8.6% compared to 2021. However, a comparison of the regions reveals significant differences in some cases.
Banks’ pre-tax profits rise again - but significantly lower than in the previous year
The increase in profitability is also evident when looking at earnings before taxes (EBT). The positive trend of the previous year continues. In 2022, European banks increased their EBT by 5.4 percent. Regional differences can also be seen here: while all regions benefitted from the economic improvement and the reversal of risk provisions as an earnings driver in 2021, not all regions could participate in the changed interest rate environment in 2022.
ECB interest rate turnaround drives up interest margins
The interest rate turnaround in spring 2022 marked a turning point in the interest margin, which had been declining for years. Following the ECB’s interest rate decision, European banks recorded a jump in margin growth of 15.8% in 2022 compared to 2021. The interest margin became the determining factor for the earnings situation. The interest income of European banks rose by 36.9% last year.
Necessary increase in risk provisioning and rising IT and administrative costs reduce banks’ earnings
Although European banks were able to improve their earnings in 2022 thanks to significantly higher interest margins, cost pressure also increased at the same time. The war in Ukraine and the growing risk of loan defaults, in particular, caused uncertainty. As a result, expenses for risk provisioning increased. IT and administration costs also increased. However, last year’s renewed tightening of the economic situation necessitated a further increase in risk provisioning, with provisioning increasing 87.4%: the energy crisis, supply chain disruptions as well as high inflation rates, rising interest rates, and fears of recession had a powerful impact. A look at the increase in risk provisioning across national borders reveals a largely uniform picture.
Low balance sheet growth - ECB long-term loans show considerable effects
A slowdown followed the strong growth in total assets during the coronavirus crisis. The increase of just 1.1% in 2022 is due to the high-value adjustments, which counteracted the rising credit volumes. During the coronavirus pandemic, there was still average growth of 7.1% in 2020 and 2021 and 2.5% in the two pre-coronavirus years of 2018 and 2019. Regional differences in balance sheets and loan volumes depended on the extent to which banks utilized the ECB’s TLTRO II and III long-term loans and whether they repaid them early or at maturity.
Common equity tier 1 ratio declines for the first time
The RWA ratio, the ratio of risk-weighted assets to total assets, remained constant for European banks. The common equity tier 1 ratio (CET1 ratio) of European banks deteriorated in 2022 for the first time since data collection began in 2013, falling from 15.9% to 15.4% compared to 2021. As the RWA portfolios have also increased in almost all regions, banks hold less equity overall - but there are regional differences here, too.
German banks’ interest rate business: just a brief upswing?
In Germany, banks managed to increase their interest margin from 0.68% in 2021 to 0.77% by the end of 2022. But how long will banks benefit from this market situation? On the one hand, this depends on the ECB’s future key interest rate decisions. But there are also other factors to consider that influence the interest margin and, therefore, future interest surpluses.
Steady downward trend in the interest margin since the mid-1990s
In 2021, the interest margin was only around half of what it was in 1994. This decline is due to several factors. The liberalization successes of global trade led to increased competition in financial services and loans - European banks competed for the emerging Asian market. At the same time, the Deutsche Bundesbank significantly lowered the key interest rate, and the internet increased the transparency of the credit on offer for companies and consumers. Over the past five years, the entry into force of the Payment Services Directive PSD2 has also accelerated the decline in interest margins in Germany - open banking has reduced information asymmetry for customers and increased competition from fintechs.
How a rising key interest rate also has a short-term effect on the interest margin
The ECB’s decision to shift from an expansive to a restrictive monetary policy in 2022, accompanied by the cessation of bond purchases and an increase in the key interest rate, brought about a turnaround. The interest margin of German banks rose significantly in the short term primarily due to the different levels of lending and deposit rates and the time lag between the respective increases.
GDP growth depresses the interest margin in the long term
There is no evidence of a structural correlation between the development of the ECB’s key interest rate and the interest margin of banks. However, looking at the gross domestic product (GDP) provides insights and allows for statistically significant conclusions about interest margins. Accordingly, interest margins can be expected to fall in line with GDP growth. The negative correlation between GDP and interest margins can be empirically proven using a regression model developed by BearingPoint.
Compensating for falling interest margins is a challenge for banks
Considering the long-term decline in margins in the interest business, the question arises as to how German banks can nevertheless secure their interest surpluses in the future. Could this be achieved by increasing lending volumes, for example? A more comprehensive picture of the lending business can be obtained by looking at the default risk indicator.
Sustainable, efficient, and growth-oriented banking is the key to sustained profitability - Our recommendations for banks:
With NEW Banking - sustainability, efficiency, growth (in German, Nachhaltigkeit, Effizienz, Wachstum) - BearingPoint provides solutions for transforming banks and securing their future profitability.
Acting sustainably - Integrating ESG (environmental, social, and governance) criteria into management and reporting processes is essential to meet new regulatory requirements. In addition, banks must establish ESG-specific data processes, a feat of strength given the diversity and complexity of the data.
Increase efficiency - Reducing costs and increasing efficiency are becoming increasingly important in the crisis-ridden economic environment and require investment in a holistic transformation. The digitalization of services and the streamlining and modernization of processes and systems save capital and resources.
Creating growth - The significant change in the interest rate environment opens higher earnings opportunities for banks - at least temporarily. Nevertheless, they should focus on the commission, advisory, and administration business, as these have been the revenue drivers in recent years. By further expanding their digital banking offerings in conjunction with new products, banks can attract new customers and, at the same time, meet the demand for holistic support for existing customers. The growing interest in sustainable investments, in particular, offers earnings potential. Banks can strengthen their market position by focusing on these areas comprehensively and at an early stage.
About the study: The study is based on an analysis of the annual financial statements of 116 European banks from 2017 to 2022. All institutions are supervised by the ECB or national supervisory authorities. Taken together, the balance sheet totals of the banks analyzed accounted for around 75 percent of the aggregated balance sheet total of all monetary financial institutions in the European Union in 2022.
