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European banks’ returns on equity (ROE) face a five-year slump, with UK banks still well below their pre-Covid-19 profitability in 2025, according to new research from McKinsey.

ROE will remain as low as about 7% in the UK and 5% in the European Union, according to the consultancy.

Across Europe, banks could see their common equity tier-1 (CET1) ratios fall as low as 8%. That compares with CET1 ratios going into the crisis of around 12% or 13%. Today, BBVA suffers the lowest CET1 ratio of European banks, according to Berenberg, with 10.8%.

McKinsey’s report, which is based on a survey of senior executives in banking and other industries, takes an unusually long and bearish view on the sector. It is based on a eurozone drop in GDP of 11% in 2020, with a recovery in late 2023. It takes into account government stimulus, but not the possible reaction from banks’ management.

Healthy banks are a critical pillar for a well-functioning economy, so banks and regulators must jointly find the way to recovery 

 – Ildiko Ring, McKinsey

According to the report, a looming hit of 40% or more on banks’ revenues after cost of risk – with no recovery before 2024 – is a scenario “more severe for banking economics than the 2007-8 financial crisis or the 2010 European debt crisis”.

European banks ROE to 2025
Outlook in muted recovery scenario and in past crises

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Source: McKinsey

Banks’ mortgage businesses – often accounting for about a third of pre-tax profit in Europe – will not recover before 2024, for example.

Defaults are the main concern. Credit losses could even be higher than the adverse scenarios in the European Banking Authority’s (EBA) stress tests: although banks’ first-quarter provisions were, on average, less than 10% of the regulator’s adverse-scenario losses, according to Barclays.

Commercial banking costs are to triple by 2021, driven by losses in small and medium-sized enterprises (SMEs), according to the report. Meanwhile, lower credit ratings for some commercial clients will also drive up capital consumption through risk-weighting calculations.

Overall, McKinsey suggests that credit losses and rising risk weights – coupled with squeezed revenues due to low margins and low interest rates – will mean an average drop of 11 percentage points of ROE in the UK in 2020 and 2021, and of six percentage points in the EU.

UK banks

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Ildiko Ring,
McKinsey

Ildiko Ring, one of the co-authors of the report, says UK banks will be particularly severely hit, not just because of the accompanying risks around Brexit but also because of a less conservative lending culture generally, notably in consumer finance.

Across Europe, liquidity coverage ratios, though strong going into the crisis, will weaken as a result of corporate clients drawing down on committed facilities, among other factors. That increases the possibility of one distressed bank triggering wider liquidity worries, according to McKinsey.

Tricky and highly dilutive capital raises, as well as even more government interventions to prop up the banks, are to be expected.

While governments and regulators will lean on banks to support the economy, one solution to banks’ capital pressures is to increase the share of loans that are secured. Banks should also move to loan pricing that is more based on the cost of capital, for example.

At a time when banks are working more closely to support governments’ loan guarantee schemes, among other things, the report suggests “moving from a control-based culture to one based on strong values supported by smart controls”.

Nevertheless, it’s clear that banks face a tension between trying to do the right things for their customers and protecting their businesses.

“Healthy banks are a critical pillar for a well-functioning economy, so banks and regulators must jointly find the way to recovery,” says Ring.

Digitalization

A customer survey by the consultancy shows that while the use of cash has halved during the coronavirus outbreak, digital engagement levels have risen by as much as 20%. At the same time, up to 40% of customers have asked for advice and new products to help them manage the crisis.

Digitalization, therefore, offers a partial way out, including better use of data analytics to support small businesses at the same time as making sure the bank is properly managing its risk and capital consumption.

“Now is the time for banking executives to reimagine how their institutions operate,” the report states.

It’s not enough. Banks need to consider carving out non-core businesses that add to their complexity, even if they are profitable, such as consumer finance and payments. Meanwhile, past experience suggests domestic bank mergers could bring cost reductions of up to 40%.

Wealth management and payments are among the brighter spots, as they should bounce back more rapidly. The consultancy expects a rebound in wealth management that is two or three years ahead of other sectors, as it notes financial assets and borrowing of the richest customers typically recover faster than the broader economy.

However, better volumes in consumer finance and bancassurance – as clients seek to tide themselves over or protect their futures – are unlikely to make up for retail banks’ hit from loan losses and lower mortgage volumes.

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