$1.3 Trln in Bad Loans Jeopardise European Banks' Profits

Kristian Rouz – Banks across Europe have accumulated a whopping 1.2 trln euros ($1.3 trln) in non-performing loans (NPLs), which is starting to hinder banking sector profitability. NPLs weigh heavily on return on issued credit and mar the forward outlook on lending in general, as expectations of loan servicing are dim. Eight years after the last global crisis, and five years after the European debt crash, commercial banks are struggling to resolve the issue, despite the European Central Bank’s (ECB) ultra-low interest rates. A high level of household indebtedness and insufficient disposable incomes prevent individual credit servicing from becoming more efficient, and the NPL issue is poised to linger for at least ten years to come.

According to a report by the global audit firm KPMG LLP, commercial lenders are unable to effectively restructure or disburse toxic assets due to massively underperforming economic growth all across Europe. Stricter government banking regulations have also hindered the efficiency of the banking sector, which is caught in the crosshair of the inept consumer phenomenon and Basel III rules.

“Successful banks will restructure their balance sheets to minimise the impact of new regulations and reduce their cost-to-income ratios through the smart use of technology,” Marcus Evans of KPMG said. “Reversing the profitability of European banks is not a lost cause but it will certainly be a lot of hard work.”

Since 2008, the total volume of NPLs has risen from roughly 1.5pc of all loans issued to over 5pc in 2013, and that figure is growing, KPMG’s report said. Meanwhile, the regulatory pressure, which has been on the rise since the implementation of Basel II rules and continues amid the release of Basel IV, will add some 0.5pc to European banking costs in the near-term.

“It’s clear that across Europe, banks are still grappling with the new world of low, or negative, interest rates and mounting capital and regulatory costs,” Evans added.

KPMG also reported that while average return on equity in Europe is about 3pc, the cost of capital stands at 10-12pc, while net interest margins are dismally low: at 1.2pc across Europe compared to 3pc in the US and 2pc in Canada.

All that said, banking in the traditional sense – issuing commercial loans for profit – is becoming increasingly unprofitable in Europe. Subsequently, as traditional lenders are exiting the financing of many projects in the real economy, growth prospects look feeble. Non-traditional lenders are occupying the niches abandoned by banks, offering flexible financing options to the economy at higher interest rates, resulting in shaky growth and mounting risks.

The nascent trend is disrupting the transmission of central bank policy to the economy – amid negative rates, a property developer or a founder of a business start-up can only count on non-bank loans at rates of 6-8pc. Meanwhile a traditional bank, which would be willing and able to issue a loan at 3pc interest under normal circumstances, is kept from engaging in such activity due to tougher regulations and NPL concerns.

The use of technology could help banks resolve the profitability issue. As observed by KPMG’s Evans, “streamlining back-office processes and moving to digital distribution channels is essential future-proofing and will ensure long-term savings.”

Nonetheless, it might takes banks “decades rather than years” to decrease their exposure to NPLs, KPMG observed, even should lending profitability recover. In the end, the patterns of loan servicing depend on consumer confidence and incomes, which are determined by economic growth.