This article originally appeared on Forbes.com.
European banks as a whole are running hard just to stand still. Sure, in light of the higher capital buffers they have erected, the banks might appear to be fairly resilient when viewed through recent stress tests by regulators. But in reality, reflections on average for European banks are next to useless in a continent of many distinct markets. A select group of banks that are performing well on a range of indicators have been increasing their lead over persistent laggards—particularly in the multiple accorded by equity investors. These winners have more than a four times price-to-book ratio advantage over those banks at greatest risk of failure or bailout.
Yet the past decade has shown that any bank at any point along the spectrum can return to good health, through a proven formula—that is, if the regulators, board and senior executive team have the commitment to carry out the hard decisions required.
These conclusions emerge from Bain & Company’s 2017 health check of the banking system, the fourth annual analysis covering 111 banks in the base study. Our health check scoring model, which brings together data from financial providers such as SNL Financial and Moody’s with banks’ own financial statements, derives from three dimensions:
- profitability and efficiency;
- asset and liability health (here, we give a relatively heavy weighting to asset quality as essential for future earnings); and
- stability of the operating environment.
The health check provides a uniquely integrated view, which stands in contrast to looking only at a balance sheet or income statement. Based on the combination of the critical financial ratios, we calculated a score for each bank and placed it in one of four categories.
- Winners. Some 38% of banks have attained this strong position. Scandinavian, Belgian and Dutch banks figure prominently in this group, outperforming on virtually all financial indicators.
- Weaker business model. Banks in this quadrant continue to represent about 17% of the total. What may surprise some observers is the number of UK and German banks, including names that used to be references for good health, struggling to find a viable business model. Virtually all the large German names fall into this category, as their profitability and efficiency sit at a level comparable with their Greek counterparts.
- Weaker balance sheet. Some 17% of banks have a priority to fix weak balance sheets, compared with 21% in 2013. Over the years, banks in this quadrant have shown vulnerabilities not yet fully reflected in their profit and loss statements.
- Highest concern. Of the total base, 28% of banks flash a high-risk signal, up from 26% in 2013. Banks in Italy, Greece, Portugal and Spain form the bulk of this quadrant and have become a breed apart in continued distress. Every bank that has failed in the past decade and for which there are financial statements available, as well as many banks that merged into other entities, fell into this quadrant before their demise.
The cost of inertia is striking, with investors rewarding the winners with a 1.31 price-to-book ratio and punishing the high-concern banks with a 0.31 price-to-book ratio. Equity markets also seem to reward banks with weak balance sheets, assigning them a slightly higher price-to-book ratio of 0.72 vs. banks with weak in-year profitability and efficiency, which were assigned a price-to-book ratio of 0.60.
Fortunately, there is a proven formula for moving up—even from the dark reaches of highest concern to the promised land of winners. The experiences of two banks illustrate that migration. What follows are examples of actions that the two banks took.
- They shrank the balance sheet. Both reduced their risk-weighted assets by about 50% and their problem loans by 70% to 75%. Restructuring troubled loans and disposing of repossessed factories took a lot of time and effort, but they persisted, having realized that allowing nonperforming assets to sit on the balance sheet would require more capital every month and further impair the enterprise.
- They grew revenue by improving customer loyalty and advocacy for the new digital world. Net interest margin as a share of risk-weighted assets more than doubled. This occurred after both banks embarked on an ambitious reassessment of the markets in which they operate. They discarded legacy bets and focused on new profit pools. Improvements to different aspects of the customer’s banking experience led to significant increases in customer loyalty and business.
- They adjusted the cost base to reinvest in new activities. Both banks decided to pursue cost reductions through what we would now call zero-based redesign programs. This differs from traditional budgeting processes by examining all expenses for each new period, not just incremental expenditures in obvious areas. As a result, one of the banks that published its performance results reduced its cost base by around 30%. Zero-basing freed up funds to reinvest in a more simple and digital business model.
- They changed the mix of funding. The two banks’ deposit levels rose by 20% to 25%, while they reduced wholesale funding by between 70% and 80%. Reduced dependency on wholesale funding marked a major departure from the previous makeup of the balance sheets.
With relatively new and ever-increasing regulatory frameworks from the European authorities taking hold, including the Supervisory Review and Evaluation Process and greater scrutiny of nonperforming exposures, European banks cannot afford to ignore any of the data that signals vulnerable points within the institution. Taking an integrated view is essential for understanding how to return to robust health. The good news: Troubled banks can likely quadruple their market value by taking the right actions.
João Soares is a partner with Bain & Company’s Financial Services practice. He is based in London.