The Banking Industry’s Dirty Secret: Profitability Issues Threaten Global Stability

9 min read

Examining Recent Banking Challenges and Persistent Profitability Issues

Despite regulatory reforms implemented after the 2008 financial crisis, recent collapses of major banks and declining profitability highlight an inherent vulnerability in the global banking system. The unease in the marketplace, including falling stock indexes, credit default swaps, and substantial losses by prominent banks, raises questions about the nature of these events.

Is it a temporary blip or evidence of a more serious problem? A deeper analysis reveals that most banks struggle to generate sufficient returns on equity (ROE), particularly in an environment of low-interest rates and sluggish economic growth. However, successful outliers like Bawag and OLB demonstrate that a different approach is possible, focusing on sound management, core competencies, and value differentiation.

Reevaluating Banking Performance in Challenging Times

Lackluster ROE: A Persistent Concern in the Banking Industry

The banking industry has been grappling with persistently low returns on equity (ROE) for a considerable period. Even in 2022, when economic conditions were relatively stable, the average ROE for European banks stood at just 6-7%, significantly below the 9-11% required to cover the cost of capital. This disparity between actual and desired ROE levels raises concerns about the long-term profitability and sustainability of banks, particularly in an environment characterized by low-interest rates and sluggish economic growth.

The prevailing belief is that these challenging economic conditions make it difficult for banks to generate robust profits. The low-interest-rate environment reduces the profitability of traditional banking activities, such as lending and interest-based income streams. Furthermore, slow economic growth limits opportunities for banks to expand their lending portfolios and generate additional revenue. As a result, many banks find themselves trapped in a cycle where they struggle to meet profitability targets, inhibiting their ability to reinvest in the business and support sustainable growth.

The persistently low ROE in the banking sector has led to a prevailing mindset that banks may not be capable of achieving sustainable profits as long as these economic conditions persist. This perception has implications for investor confidence, as shareholders seek attractive returns on their investments. If banks continue to underperform, it could lead to a loss of trust and further erosion of investor sentiment, exacerbating the challenges faced by the industry.

Success Stories: Bawag and OLB’s Resilience and Profitability

Breaking the Mold: Bawag and OLB’s Exceptional Cost-to-Income Ratios

Despite operating in highly competitive markets with traditionally low profitability, Bawag and OLB have demonstrated exceptional resilience and profitability. A key metric that highlights their success is the cost-to-income ratio, which measures the efficiency of a bank’s operations. In 2022, while the European average cost-to-income ratio was a relatively high 59.7% for the first half of the year, Bawag and OLB achieved significantly better figures: 35.9% and 42.3%, respectively.

These impressive cost-to-income ratios reflect the effectiveness of Bawag and OLB in managing their operational expenses and generating income from their core activities. Several factors contribute to their ability to outperform their rivals:

a) Focused Operations: Both Bawag and OLB have avoided the temptation to be all things to all people. Instead of engaging in a “universal” banking model that encompasses numerous business lines with varying risk and return profiles, they have strategically focused on their core competencies. This approach allows them to allocate resources and efforts more effectively, avoiding the dispersion of capital into unprofitable or peripheral areas.

b) Effective Management: Bawag and OLB prioritize sound and solid management practices. By adhering to fundamental banking principles and emphasizing risk management, they reduce the likelihood of significant losses due to poor decision-making or inadequate control over risk factors. These banks prioritize prudent lending practices, maintain strict internal controls, and employ a proactive approach to risk identification and mitigation.

c) Value Differentiation: Bawag and OLB have successfully differentiated themselves from their competitors by creating a unique value proposition. Instead of attempting to cater to all customer segments or offer a broad range of products and services, they concentrate on specific target audiences and excel in providing tailored solutions that meet their needs effectively. This targeted approach allows them to develop a competitive advantage, attract customers, and command a pricing premium.

Embracing a Recipe for Success: Core Competencies and Differentiation

Building on Solid Foundations: Doing the Banking Basics Right

One of the fundamental principles that contribute to the success of banks like Bawag and OLB is their commitment to doing the banking basics right. They prioritize the core functions of banking, such as prudent risk management, effective customer service, and efficient operations. By excelling in these fundamental areas, they establish a solid foundation for sustainable profitability.

One significant lesson learned from the downfall of banks like Silicon Valley Bank (SVB) is the criticality of sound risk management. SVB’s poor control of interest rate risk played a substantial role in its collapse. In contrast, banks like Bawag and OLB have implemented robust risk management frameworks that enable them to identify, assess, and mitigate risks effectively. They understand the importance of striking the right balance between risk and reward, avoiding excessive exposure to high-risk activities while still pursuing profitable opportunities.

Focusing on Core Competencies and Eliminating Underperforming Business Lines

Another key aspect of success for Bawag and OLB is their focus on playing to their strengths and concentrating on their core competencies. They recognize that trying to be all things to all people can lead to a diffusion of resources and dilution of expertise, resulting in suboptimal performance. Instead, they strategically identify their areas of expertise, whether it’s investment banking, private banking, commercial banking, or other specific niches, and double down on delivering exceptional value within those domains.

This strategic focus allows them to allocate resources more efficiently, concentrate their efforts on areas where they have a competitive advantage, and drive profitability. It also enables them to differentiate themselves from their competitors by developing a deep understanding of their target audience’s needs and tailoring their products and services accordingly. By eliminating opportunistic and sub-scale business lines that underperform, they can redirect their resources towards initiatives that offer long-term sustainable competitive advantages.

Creating a Unique Value Proposition for Long-Term Competitive Advantage

Bawag and OLB recognize the importance of developing a unique value proposition that sets them apart from their competitors. They understand that a one-size-fits-all approach is not effective in a highly competitive banking landscape. Instead, they invest in understanding their target audience’s specific requirements and preferences, and they design their offerings accordingly.

By focusing on specific customer segments and delivering tailored solutions, they establish a strong value proposition that resonates with their target market. This unique value proposition allows them to attract and retain customers, even in highly competitive markets. It also enables them to differentiate themselves from larger, more diversified banks that may struggle to offer the same level of specialization and customization.

Overcoming Inertia: The Urgency for Radical Change in the Banking Industry

The Temptation of Inertia and the Status Quo

Despite the need for transformation and adaptation, the banking industry often faces a significant challenge: the temptation to stick with the status quo. Many banks are reluctant to embark on rapid and radical changes due to concerns about the associated expenses, complexities, and risks. This inertia can hinder their ability to become more resilient and profitable organizations.

Maintaining the status quo may seem more comfortable in the short term, as it avoids the immediate costs and potential disruptions associated with significant changes. However, in the long run, it leaves banks vulnerable to the evolving dynamics of the financial landscape, including increasing regulatory requirements, disruptive technologies, and shifting customer expectations. Failure to adapt proactively can lead to missed opportunities, declining competitiveness, and even financial instability.

The Need for Radical Change in the Face of Market Pressures

The urgency for radical change in the banking industry becomes even more critical in light of external market pressures. Central banks’ more aggressive approach to interest rates, driven by the need to combat inflation, adds further complexity and challenges to banks’ operations. Higher interest rates can burst asset bubbles, leading to potential losses and vulnerabilities for banks. This, combined with the loss of trust resulting from recent bank collapses and emergencies, highlights the imperative for banks to put their collective house in order.

As primary sources of personal and commercial financing, banks play a crucial role in supporting the real economy. However, excessive allocation of capital to trading activities, at the expense of core banking functions, detracts from their ability to fulfill this role effectively. To regain investor trust and create shareholder value, banks must prioritize activities that directly contribute to sustainable economic growth and focus on delivering reliable and valuable financial services.

Embracing Radical Change for Resilience and Profitability

To overcome inertia and embrace radical change, banks must adopt a proactive mindset and take decisive actions. This involves reevaluating their business models, streamlining operations, and transforming their organizational cultures to be more agile and innovative. Key considerations for banks seeking transformation include:

a) Embracing Digital Transformation: Banks must leverage technology to streamline processes, enhance efficiency, and deliver personalized and seamless customer experiences. Investing in digital banking solutions, automation, artificial intelligence, and data analytics can drive operational excellence and improve customer engagement.

b) Reinventing Revenue Streams: Banks should explore new revenue streams beyond traditional interest-based income. This may involve developing innovative products and services, collaborating with fintech partners, and exploring opportunities in areas such as wealth management, sustainable finance, and digital payments.

c) Enhancing Risk Management Capabilities: Strengthening risk management frameworks and practices is crucial for navigating an increasingly complex and volatile financial landscape. Banks should invest in advanced risk assessment tools, develop robust compliance programs, and prioritize proactive risk identification and mitigation strategies.

d) Cultivating a Culture of Innovation: Banks need to foster a culture that embraces innovation, agility, and continuous learning. Encouraging collaboration, empowering employees to experiment and take calculated risks, and creating incentives for innovation can drive positive change and enable banks to stay ahead of evolving market trends.

By embracing radical change, banks can position themselves for long-term resilience and profitability. Taking proactive steps to adapt to market dynamics, leverage technology, and transform their operations and cultures will enable them to navigate challenges, regain investor trust, and deliver sustainable value to their stakeholders.

The Role of Banks in Supporting the Real Economy and Creating Shareholder Value

Banks as Drivers of Economic Growth

Banks play a crucial role in supporting the real economy by facilitating the flow of capital, providing financing to businesses and individuals, and enabling economic growth. When banks effectively allocate capital to productive investments, they contribute to job creation, innovation, and overall economic development. However, recent challenges and disruptions in the banking industry have raised questions about their ability to fulfill this role effectively.

Restoring Trust and Rebuilding Confidence

The collapse of banks like Silicon Valley Bank (SVB), the emergency merger of Credit Suisse, and the demise of First Republic have eroded trust and confidence in the banking sector. Restoring trust is of paramount importance for banks to regain their credibility and ensure their long-term sustainability. This requires transparency, accountability, and a commitment to ethical conduct.

Banks must demonstrate that they have learned from past mistakes and implemented robust risk management practices. Open communication with stakeholders, including customers, shareholders, and regulatory authorities, is essential to rebuild confidence in the banking system. By being proactive in addressing issues and taking responsibility for their actions, banks can gradually restore trust and strengthen their relationships with key stakeholders.

Creating Shareholder Value through Sustainable Profitability

Creating shareholder value is a primary objective for banks and their investors. However, achieving sustainable profitability in a challenging banking environment requires strategic focus and proactive measures. Banks must identify and capitalize on opportunities to generate revenue while managing risks effectively.

By embracing the principles discussed earlier, such as focusing on core competencies, eliminating underperforming business lines, and creating a unique value proposition, banks can enhance their profitability and generate long-term shareholder value. Additionally, embracing radical change, such as digital transformation and innovation, can open up new avenues for revenue growth and cost efficiency.

Aligning with Stakeholder Expectations

In addition to creating shareholder value, banks must also align with the expectations and needs of other stakeholders, including customers, employees, regulators, and the broader society. Meeting these expectations involves providing excellent customer service, ensuring fair and responsible lending practices, complying with regulatory requirements, and embracing corporate social responsibility.

By adopting a customer-centric approach, banks can strengthen customer relationships, enhance loyalty, and attract new business. Prioritizing fair and responsible lending practices, including promoting financial inclusion and sustainability, aligns banks with societal expectations and supports the broader economic and environmental goals of the communities they serve.

Balancing Profitability with Social Impact

While profitability is essential for banks, it is equally important to strike a balance between financial success and social impact. Banks that prioritize social responsibility and environmental sustainability not only contribute to the well-being of communities but also strengthen their long-term viability.

Through initiatives such as responsible investment practices, support for small and medium-sized enterprises (SMEs), and sustainable financing options, banks can align their profitability goals with social and environmental objectives. This alignment not only enhances their reputation but also attracts socially conscious customers and investors who value the positive impact generated by responsible banking practices.

A Call for Immediate Action and Lasting Change

The challenges faced by the banking industry underscore the need for immediate action and lasting change. While recent collapses and emergencies have highlighted vulnerabilities, they also provide an opportunity for reflection, adaptation, and transformation. The consequences of inaction are too great to ignore, as they can lead to further instability, loss of trust, and missed opportunities.

Banks must recognize that the status quo is no longer viable in an increasingly complex and competitive landscape. They need to embrace radical change, both in terms of their operational strategies and their organizational cultures. This requires a proactive mindset that prioritizes innovation, agility, and continuous learning.

Digital transformation is a key enabler of change, as it allows banks to streamline processes, enhance customer experiences, and unlock new revenue streams. Embracing technology is not an option; it is a necessity for banks to stay relevant and competitive. Additionally, banks must reevaluate their business models, focusing on their core competencies and shedding unprofitable and opportunistic business lines. This will enable them to create a unique value proposition that sets them apart from their competitors.

Risk management capabilities must be strengthened to navigate the increasingly volatile financial landscape. This involves investing in advanced risk assessment tools, developing robust compliance programs, and adopting proactive risk identification and mitigation strategies. By enhancing risk management practices, banks can minimize potential losses and protect themselves against unforeseen disruptions.

Cultural transformation is equally vital. Banks must cultivate a culture that encourages innovation, collaboration, and a willingness to challenge the status quo. This requires empowering employees to experiment, take calculated risks, and embrace a mindset of continuous improvement. Creating incentives for innovation and providing opportunities for professional development can drive positive change and foster a culture of adaptability and resilience.

Moreover, banks must restore trust and rebuild confidence among their stakeholders. Transparency, accountability, and ethical conduct are crucial for this process. By communicating openly, addressing past mistakes, and demonstrating a commitment to responsible banking practices, banks can gradually regain trust and strengthen their relationships with customers, shareholders, and regulators.

In conclusion, the banking industry stands at a crossroads. Immediate action is required to address existing vulnerabilities and adapt to evolving market dynamics. By embracing radical change, leveraging digital transformation, strengthening risk management capabilities, and fostering a culture of innovation, banks can position themselves for long-term resilience and profitability. The time for lasting change is now. Banks must seize the opportunity to shape their future and fulfill their critical role in supporting the real economy, creating shareholder value, and contributing to sustainable economic growth.