16 October 2024

SSM's Buch: Bank profitability: a mirror of the past, creating a vision for the future

The history of banking contains many examples of institutions that reported high profitability before failing. It concealed underlying risks and proved to be illusory. Before the global financial crisis, bank profitability was relatively high but the profits declined sharply and turned into losses.

Banking regulation and supervision have significantly improved since then. Regulation has been reformed at the global level, requiring banks to be better capitalised and more liquid, while the Single Supervisory Mechanism, underpinned by the Single Rulebook, has been established.

Bank profitability in Europe has increased in recent years. In some ways, the current levels of bank profitability mirror the past – structurally, by reflecting differences in markets and banks’ business models, and more cyclically, by reflecting the changing macroeconomic environment and higher interest rates. This raises the question as to whether profitability is a good metric for assessing bank resilience or if there are other indicators we should consider.

In a market economy, profitability is a key performance indicator. It is highly correlated with business models, productivity and, in this sense, the contribution that firms make to economic welfare. Banks are no exception here.

At the same time, profitability does not measure firms’ contribution to welfare more broadly. Generally, a high degree of profitability can signal excessive market power. In the financial sector, it can be difficult for outsiders to verify the quality of services provided and the underlying risks. High profitability can therefore also signal excessive risk taking or even fraudulent behaviour. Banks and their shareholders may take on more risk than is socially acceptable if there are potentially great rewards to be had and only limited downsides. Seeking to maximise profits in the short term can be detrimental to the longer-term sustainability of a business model. In addition, the public cares a great deal about banks’ stability and resilience since banking crises can come at a significant cost to the taxpayer.

These considerations have three main implications for banks and supervisors.

First, high levels of bank profitability reflect good management and business franchise, but also good luck and a favourable macroeconomic environment in the short term. Some factors driving profitability are under the control of individual banks, others are not. Some are correlated with higher long-term resilience, others are not. Good risk management by banks needs to take these distinctions into account.

Second, supervisors’ assessments of bank profitability focus on the long term. Factors that drive up profitability in the short term may come at the expense of weaker long-term stability. In particular, a high short-term return on equity without due consideration for the underlying risks is not necessarily conducive to bolstering resilience and maintaining financial stability. All other things being equal, lower equity capital increases the return on equity, but it also reduces bank resilience. More risk taking increases returns, but also leaves banks more vulnerable to shocks. This is why good supervision ensures that banks focus on their long-term profitability, anchored by a resilient and sustainable business model, governance structures that prevent excessive risk taking and sound capital planning that takes future uncertainties into account.

Third, banks’ future profitability is shaped by their ability to respond to changes in the external environment, particularly the digitalisation of financial services. These services may increasingly be provided by strongly capitalised big tech companies with large IT budgets. They may also increasingly be provided across borders, which would reduce the importance of any inherited comparative advantage in local markets. Banks therefore need to find strategic responses to these challenges. They need to invest in IT and cybersecurity to improve their cost efficiency and take advantage of scale effects. Today’s high profitability levels provide banks with a window of opportunity to invest in their vision for a long-term, sustainable business model in a world of digital finance.... 

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