The EBA has published its latest risk assessment for the European banking sector

Introduction

The tenth report on risks and vulnerabilities in the European banking sector has been published by the European Banking Authority (EBA). The 2017 EU-wide transparency exercise accompanies the report, and displays data collected from 132 banks across the EU.

The report highlights the increasing resilience of the banking sector amidst favourable macroeconomic and financial developments. Improvements can be observed in banks’ capital positions, funding and, to a lesser extent, in terms of asset quality and bank profitability. The EBA notes, however, that further progress is generally required in addressing issues relating to NPLs and the long-term sustainability of business models, both of which remain a high priority concern within the sector.

Robust data management, IT security and operational concerns have been highlighted as important risk drivers going forward, as banks embrace digitisation strategies and attempt to counter competition from ambitious FinTech competitors. In the process, banks are increasingly outsourcing IT and data management functions to third-party service providers, which in turn requires additional controls within the context of outsourcing risk. These considerations are all the more important considering new regulatory priorities such as the incoming General Data Protection Regulation (GDPR) and the revised Payment Services Directive (PSD2), both of which come into effect next year.

Conflicting results in NPL reduction and profitability

Despite registering general marginal improvements in overall profitability and the NPL ratio, the EBA has expressed caution in the manner in which results are interpreted by European banks.

On the one hand, a general decline in the NPL ratio reflects progress made by EU banks to clean up their balance sheets, which has in turn helped improve banks’ capital position through the lowering of credit risk weighted assets. However, the EBA points out that about one-third of EU jurisdictions have NPL ratios above 10% and the level of NPLs still remains at a concerning historical level (EUR 893 billion).

Profitability has also improved slightly and is currently at its highest level since 2014 (7.0%). This is largely due to a decrease in impairments, lower funding costs, an increase in fees and commissions and an improvement in trading profits. However, profitability still remains a challenge as the average RoE has remained below the cost of equity and banks are still struggling to generate sufficient margins through their traditional lending activity. Furthermore, the implementation of IFRS 9 is expected to lead to higher provisioning, which will in turn have a negative impact on profitability and capital adequacy, the extent of which varies across the banking spectrum.

How can EU banks address these concerns

To address these challenges, EU banks must adopt the following strategies:

• A review of the business model – Higher operating efficiency and lower cost/income ratios, and increased capabilities to generate revenue and/or tight cost control. Funding will become increasingly important as the European economy grows and central banks reconsider current rates. Business model reviews also tend to focus on improving the customer experience as a response to the rise of FinTech companies and other third parties attempting to break into the market.
• A robust NPL reduction strategy – A number of strategies for reducing exposure to NPLs exist, ranging from internal exercises undertaken by the bank originally holding the impaired asset, to directing sale to investors, offering an opportunity to dispose of NPLs quickly. The riskiness of business lines pursued in lending is also relevant from a strategy perspective.
• Cyber risk resilience – Has fast become a top priority for global regulators. In particular, banking supervisors are looking to ensure that banks are cyber resilient, and have the appropriate risk management controls and procedures in place to withstand and respond to cyber-attacks.
• Partnerships - Partnerships between incumbent banks and FinTech companies are likely due to the prospect of the high levels of competition in the payments services market due to the adoption of PSD2 next year. This could benefit banks by allowing them to focus on their core business activities as well as allowing them to profit from a changing financial market, as well as a potential increase in revenue streams. However, banks must ensure their outsourcing approach is well-aligned to banking regulation and that the necessary oversight and controls are in place.

How can we help

• Business model analysis. Assistance in the preparation of a ‘business model analysis and report’ to help you defend and demonstrate the viability and sustainability of your business model and strategy to the regulator.
• Risk appetite framework. Assistance in setting up a risk appetite framework that dovetails with your business model, identifying and setting adequate quantitative metrics and qualitative tolerance levels.
• NPL reduction plan. Assistance in the preparation of NPL reduction plans in line with Banking Rule 09 and ECB guidance on NPLs.
• Credit on-site inspection readiness. Assistance in achieving readiness to undergo either a full-scope or a targeted AQR-type assessment in line with the ECB AQR methodology.
• Data security and privacy. Assistance through end-to-end GDPR and PSD2 services, ranging from detailed gap analysis and diagnostic exercises to lifecycle mapping and implementation.
• Outsourcing strategy. Assistance in ensuring your outsourcing policy and procedures for determining permissibility and materiality of any services you intend to outsource are in line with Banking Rule 12.