In our 2020 report, Aim for revival. Not just survival. we found Europe’s banks on-track to survive the consequences of the pandemic but not yet positioned to thrive in its aftermath.
A year on consumers have faced fundamental changes to their daily lives. Whole sectors of the economy have been shut down for months at a time, with those remaining open having to adapt to entirely new ways of working. Banks have had to react at breakneck speed to various public-sector led initiatives and faced real disruption.
As banks start to look to the future, our 2021 European Banking report examines what has changed, and how banks can drive the European recovery.
How European banks withstood the pandemic
The banking system has proven resilient during one of the steepest drops in gross domestic product (GDP) ever experienced. Capital levels built-up after the financial crisis have proven sufficient, while unprecedented levels of government support have blunted or deferred many of the pandemic’s economic impacts. One in three banks already has now released credit provisions. Bank revenues and asset bases have of course been hit; in countries with the most stringent lockdowns and heavily exposed economies, revenues dropped up to 11 percent and risk-weighted assets fell nearly 5 percent. Half of the industry’s capital sits in banks with a return on equity of less than 4 percent.
The banking system has acted as the transmission mechanism for emergency governmental economic policy. Banks have made operating model changes that few would have been willing to try in normal times – branches closed, all staff working from home, processes redesigned overnight. There is now a unique opportunity to lock in new customer and workplace behaviors and drive costs out.
Much-needed rationalization has continued, with geographic footprint, segment, and product offerings streamlined. Consolidation has occurred in some countries, and authorities are signaling they expect more to follow.
That is not to say the outlook is benign – from a macroeconomic perspective, the toughest tests are still to come. Asset bubbles are inflating, caused by excessive market liquidity, low interest rates, and a speculative frenzy in digital assets. The return of inflation and interest rate rises may bring top-line growth, but swathes of corporates are still suffering from weak profitability and would be exposed, along with households.
How European banks can drive the recovery
Europe’s banks have a once-in-a-lifetime opportunity. By supporting the recovery from the pandemic and helping to tackle some of the big issues facing Europe’s economy, the sector can gain a strong sense of purpose, grow the bottom-line, and ensure its ongoing relevance. The alternative is being gradually sidelined, pushed into a diminished role by a combination of public policy measures and new ways of delivering payments and credit. There are five challenges they need to address to do this effectively.
Five challenges European banks need to address
Challenge 1 – Transition from the emergency
Action needed: Standardized approaches and collaboration to minimize solvency issues and further support businesses
Indicative revenue equivalent: €20 billion in 2022 and 2023
As the pandemic period ends, it will fall to banks to help unwind emergency lending programs while minimizing insolvencies and the number of “zombie” companies. Standardized approaches should be delivered across the industry, with government buy-in. Banks and other private-sector financial providers may need to invest in equity-like instruments for viable but overly leveraged companies. A successful glide-path out of emergency support could ensure losses do not reach the peaks predicted in 2020.
Challenge 2 – Rollout of new public-sector backed lending approaches
Action needed: Lead on coinvesting in recovery, strengthening corporate finance advisory, moving to co-investment model
Indicative revenue equivalent: €20 billion (Next Generation) + €15-20 billion (Capital markets Union)
The corporate credit market is changing, and banks will need to define their role. The European Union’s Next Generation fund is being rolled-out over the next two years and the Capital Markets Union (CMU) is slowly emerging with a long-forecast shift to market-based financing. Both are material. The €750 billion Next Generation fund amounts to 16 percent of outstanding loans to non-financial corporations in the European Union. The CMU has the potential to drive market-based financing of corporates from 25 percent to 50 percent. Banks will need to be trusted advisors, channel different forms of capital, and help clients navigate the broader range of financing solutions.
Challenge 3 – Supporting the climate transition
Action needed: Developing the financing opportunities, leading on the change agenda
Indicative revenue equivalent: €25-50 billion
Next is the carbon transition and the sustainability crisis. An estimated €1.5 trillion to €2 trillion needs to be invested in the green economy in Europe. Banks have pledged to reach net-zero carbon emissions across their lending portfolios by 2050, yet their commitments are running far ahead of the transition in the real economy. To hit their targets banks will need to be proactive in initiating transition projects. Conflicts between climate goals and financial returns may need to be managed, but if banks don’t take the initiative, a combination of boutique advisors and specialists, data companies, and private equity funds will bridge the gap.
Challenge 4 – Supporting the digital economy
Action needed: Banking as a service partnerships, closing the customer service gap, Beyond Banking offerings
Indicative revenue equivalent: €40 billion
Over the next 10 years it is possible that new ways of accessing banking products could make up 10 percent of the non-mortgage credit, deposits, FX, and payments markets for retail and SME customers. Given that these new ecosystems tend to provide shorter term, higher margin products this could equate to €40 billion in revenue. Banks will need to be aggressive here to compete with fast-moving fintech and big tech players and develop customer-first services and ecosystems, or settle on one of a number of different partnership approaches providing embedded finance.
Challenge 5 – Building new financial infrastructure
Action needed: Design and build the solution – expand the positive role of banks
Indicative revenue equivalent: €10-25+ billion
Finally, radical changes in Europe’s underlying financial infrastructure are on the horizon. Central bank digital currencies (CBDCs) are being initiated as a result of geopolitical and monetary policy control concerns. These currencies could be truly disruptive, with €10 billion to €25 billion of revenue at risk if CBDCs attract 20 percent of total deposits. More broadly, the banking system needs to take a collaborative approach, engaging with policymakers and regulators, and with each other, to identify and deliver system-wide improvements. Payments and financial crime initiatives are underway, and further initiatives across cost efficiency and data can deliver a more resilient and efficient system. Digital identity is another key opportunity where a successful cross-industry approach could strengthen banks’ bond with customers and limit big tech encroachment.
Amid all this, the work of footprint rationalization, consolidation, digitization, and cost reduction must go on. A further cost-income ratio reduction of 5 percentage points should be targeted, saving at least €30 billion.
Across these new opportunities and shifts in existing businesses, the equivalent of 25 percent of current bank revenue equivalent is on the table. If banks can rise to the challenges it will reinforce customers’ trust and their central position in the economy. If they don’t, banks will be coerced into supporting the public agenda and face the same shareholder activism recently experienced in the oil sector. Embracing change and leading the recovery is the best way for banks to thrive and avoid being sidelined.
Banks have the opportunity to take an important leadership role in the economy in a way that is vastly different from the recent past. This has the potential to reignite a stronger sense of purpose, with banks part of the solution on big issues. This can reinforce the level of trust in banks, allowing them to forge stronger and deeper relationships with their customers and serve a broader set of their needs – enabling banks to truly thrive. But banks need a new mindset and capabilities to deliver this change. In the transition there will inevitably be a tension with the narrow goal of maximizing shareholder value in the near-term.
Banks that do not step up risk either being marginalized or coerced into doing governments’ bidding anyway – but without the benefits of being on the front foot.