Squeezed Banks?

Paw Hanghøj Kellner & Jonas Kiil Pedersen

Student thesis: Master thesis


The objective of the thesis is to investigate whether or not the European banking industry will generate excess returns, prospectively. To investigate this, the subject that is considered is the Stoxx Europe 600 Banks SX7P index. Return on equity (ROE) for the SX7P-banks has the past 2.5 years been 3.3% on average. This is far below the market implied cost of equity of 9-11%. Cost of equity is determined by inferring the historical cost of equity and relying on experts’ statements. Consequently, ROE must rise to a much higher level than the current level to be able to generate excess returns. The future prospects for ROE are evaluated by analyzing the environment surrounding European banks and the competitive landscape. The important environmental factors influencing European banks are regulation, the European economy (GDP growth and interest rates), technology and social culture. Regulation is a straightjacket for banks’ operations. The European banks must be compliant with Basel III implemented trough CRD IV and CRR no later than 2019. Capital adequacy requirements pressure banks’ ROE by requiring increased quality and quantity of tier 1 equity and by tightening the calculation of riskweighted assets. Liquidity requirements force banks to hold a sufficient amount of ‘flight-to-quality’ assets corresponding to expected cash outflow in a 30 day stressed market scenario. Furthermore, it forces banks to have sufficient stable funding to cover long-term illiquid assets. Both requirements have a negative effect on net earnings. The demand for ‘flight-to-quality’ assets will increase, driving the price up and subsequent expected return down. This effect is especially severe with currently extreme low interest rates. The demand for individuals’ deposits, which are considered most stable also rises, which pressures the deposit margin. Lastly, the leverage ratio sets an upper cap to how high leverage banks can take. The European economy is at a fragile state, with sluggish and uncertain GDP growth and historically low interest rates. Banks ROE are highly sensitive to the economic conditions and a strengthening of the economic condition would lead to a rise in ROE. Positive GDP growth leads to higher lending demand in the economy, lower expected credit losses and fewer defaults. Increasing interest rates have a contrasting effect on ROE, but the negative effects are overpowered by the increase in net interest income. The digital revolution is driven by both technological and socio-cultural changes. Several industries have been transformed due to the digital revolution. People interact increasingly through digital channels. This combined with the expanding sharing economy makes disruption possible. These changes require the banks to transform their internal and external processes and invest heavily in innovative technological solutions. Whether this development will increase or decrease future ROE Side 3 af 136 is ambiguous – on the one hand the investments will make operations more efficient on the other hand the competition increases. The overall competition has increased and will probably increase in the future as well. This is catalyzed by the digital revolution. Since the financial crisis, the European banking industry has gone through a massive consolidation as a result of an overbanked Europe. The entry barriers for banks are massive, but fintech companies exploit holes in the barriers to substitute banks’ financial services. These small, agile and highly focused companies wish to skim the cream of the high-margin products and services. Fintechs have advantages operating in an unregulated grey zone, with significantly lower overheads and most importantly having the technological edge and narrow focus to better satisfy customers. Fintechs’ expansion is limited for various reasons: It isn’t straightforward to acquire society’s tillid, fintechs are dependent on banks infrastructure and fintechs don’t want to grow too big and become systemically important, since it would be accompanied with regulation. Customer mobility has increased through increased transparency, increased use of digital channels and a shift towards a sharing economy. This results in a higher bargaining power for customers. The importance of tech-employees and the fact that they can work for fintechs instead of banks both increase the bargaining of these employees. Individuals’ deposits are more attractive due to regulation requirements, which increase the bargaining power of individuals. Overall the competition has increased in the banking industry, and this is expected to continue. This will weaken banks’ profitability. The thesis cannot conclude with certainty whether European banks’ ROE will increase to a level at around 9-11% or not. However, with the current level of 3.3% in mind ROE must increase substantially. ROE will likely increase a lot when the European economy strengthens. But whether it can reach 9-11% is far from certain as regulation is a straightjacket for banks’ ROE and because the competition has increased, pressuring future earnings.

EducationsMSc in Finance and Accounting, (Graduate Programme) Final Thesis
Publication date2016
Number of pages136