Despite the economic turmoil, over-optimism persists at many banks, countries, and regulatory bodies. Even among banks that haven’t taken bailouts, many remain unhealthy, as they hold assets that will deteriorate given the contracting economies in Europe.
Some healthy banks hold mortgages and other loans that are mispriced and unlikely to ever make money on the spread between what they charge and their true cost of funds. Other banks are burdened by the “sovereign carry trade,” where the bank borrowed money from the ECB at low rates and then bought sovereign bonds at the behest of its own government and the ECB. While banks currently profit from these bonds, they could realize losses if the bonds are ever marked to market or if the sovereign defaults. And the bonds don’t help the banks restore their core businesses to health.
For the European banking system to recover, each bank needs to embrace five hard lessons gleaned from experience so far.
First, each must answer the question why should this bank exist? The question demands a convincing business case – how the bank can make money and attract deposits in the current tough economy and low-interest-rate environment. For nearly all countries in Europe (with the possible exception of Germany) there is no return to “normal” prosperity on the horizon.
Banks need to fund themselves without monetary authority assistance; otherwise investors will never perceive the banks as viable on their own. To raise the odds of self-funding, first movers have an advantage because the credit, funding, and equity markets will continue to dry up as the crisis unfolds.
The second lesson is to build a sturdy Volkswagen not a Ferrari. Ordinary citizens still need to buy homes, save for retirement, and keep deposits in a conservative, safe bank. Such services should be offered in a transparent and fair way through reasonable, risk-adjusted fees and good customer service. That might sound obvious, but some banks’ current stance toward customers is archaic. Customers want and deserve longer service hours and engaged, knowledgeable staff when they need advice. For routine transactions, customers are already embracing self-service; mobile banking usage, for instance, has doubled in the past year in many markets as customers find this channel intuitive and convenient.
Third, assume the crisis will continue for a long time – this year’s stress case will likely be next year’s base case. Today’s view is just a snapshot of the parade of bad loans passing through. Accept that losses will be higher than initial estimates, as bad loans come in waves with corporate real estate first, then unsecured credit, then small business loans, and finally residential mortgages.
Fourth, go further and faster on restructuring. Mortgage originations in most European countries are down 70-95% from their peak in 2007 or 2008, and even five years from now will likely still be down 60-85% from the peak. Based on volumes of activity and current cost structures of many banks, operating costs may need to fall by 20%-45% and the balance sheet by 50%-75%, through closing or selling branches, products, business lines, and even entire regions.
The goal should not just be to take out cost, but also to build a bank that’s easier and simpler for customers to use and for executives to run. For example, many banks have over 30 types of variable rate mortgage alone, yet more than 80% of revenue typically comes from just three to five types; the other types are too complex for customers to understand or sales people to explain.
Fifth, dig beneath the averages to find the path to profitable growth. Even in the hardest-hit economies such as Spain, Ireland, or Portugal, groups of healthy small- and medium-size businesses and middle-class households exist that constitute good risks.
Serving them profitably requires understanding how to make money today. Several years ago many Eurozone banks made 70-80% of their profit from the wealthiest one-fifth of the customer base. Now European banks typically make 100-200% of their profit on the wealthiest customers and break even or lose half of that profit on the rest, yet the overhead to serve unprofitable customers has barely budged since 2008. With high-value customers in particular, banks need to focus on the “moments of truth” that make or break customers’ loyalty, because loyal customers buy more banking products, stay longer, and urge others to become customers.
Amidst the crisis, healthy banks will have a great opportunity to move ahead while their competitors struggle. Growth is possible, but only for those that confront the reality in these tough lessons.
John Ott, João Soares and Henrik Naujoks are partners in Bain & Company’s financial services practice. Ott and Soares are based in London, and Naujoks is based in Dusseldorf.