Publication of two reports on the EU banking sector

The European Central Bank (ECB) has today published the Report on EU banking sector stability and the Report on EU banking structures. Both publications have been prepared by the Banking Supervision Committee of the European System of Central Banks, which comprises representatives of the national central banks and banking supervisory authorities of the EU and the ECB. The two reports are annually prepared by the Committee and were already published in the recent past.

This report assesses the financial soundness and risk-absorbing capacity of the EU banking sector in 2003 and the first half of 2004 separately for the 15 old EU Member States (EU-15) and the ten new Member States. For both groups, the report examines the implications of recent developments in the economy and financial markets on banks' performance.

Despite the broadly positive results of banks in 2003 and the cautiously positive outlook, a prudent approach to analysing banking sector stability requires highlighting and evaluating the implications for banks of potential, albeit relatively remote, sources of downside risk to the most probable outcome.

The contents of the report can be summarised as follows:

Profitability and solvency of the EU-15 banks in 2003 and up to mid-2004: following two consecutive years of decline, the aggregate profitability of the EU-15 banks recovered in 2003 and consolidated in the first half of 2004. This occurred in the context of a better operating environment, in which the profitability of large firms started to improve and equity markets recovered. The main sources of profit improvement were non-interest income, further cost-cutting and reduced provisioning. However, net interest income – the core component of banking sector profitability – remained sluggish, owing mainly to narrow interest rate margins and slow growth in lending to non-financial firms. Banks also increased their solvency buffers. By mid-2004 the levels of regulatory solvency ratios of EU banks had further increased.

EU-15 banks’ risk outlook: improvements in banks’ profitability broadened in the first half of 2004. On the basis of expectations of growth in net interest income and improvements in asset quality, the general outlook for the EU-15 banking sector is cautiously positive. However, some pockets of fragility may remain within the sector, as well as some important external risks. Banks have large exposure to small and medium-sized enterprises and sluggish domestic demand growth has so far hindered SME’s full recovery. In countries where house prices have risen rapidly, a reversal of this trend could pose problems for banks by lowering household wealth and collateral values. Nonetheless, the overall household loan portfolio could pose a risk of large losses for banks only in the event of several negative factors occurring simultaneously. Banks are also exposed to risks from financial markets. In the present low-yield environment, banks may – in a hunt for yield – have increased their exposure to interest rate risk and emerging market economies. There are, however, indications that banks’ exposure to interest rate risk is manageable under reasonable swings in long-term interest rates. Forward-looking market-based indicators of the financial health of the sample of large EU-15 banks (equity market-based signals, subordinated debt spreads and ratings) continued to improve after the end of 2003, pointing to a more optimistic assessment of banking sector profitability and banks’ external conditions. This positive trend can also be seen as a forward-looking assessment that the future risks for banks are manageable for the majority of large banks in the sample.

Banks in the new Member States: The condition of the banking sectors in the ten new Member States was generally favourable in 2003 and the first half of 2004. Buoyant lending to households compensated for a narrowing of lending margins. However, there was no clear improvement in banks’ cost efficiency. Banks benefited from an enhancing of asset quality, which allowed for reduced provisioning and further boosted profitability. Capital ratios remained high. As far as the risks facing banks in the new Member States are concerned, recent rapid credit growth may pose some challenges in the future. Furthermore, exchange rate risks may be of importance in these countries. Finally, while strong links between the banking sectors of the EU-15 and the new Member States could provide possible channels of contagion, they are not deemed to be a source of fragility to the EU-15 banking sectors, and EU-15 subsidiaries located in the new Member States have been able to enhance their risk management via knowledge transfer from their parents.

This report reviews the main structural developments in the EU banking sector in 2003 and, where possible, in the first half of 2004. It also contains two short topical studies: one on EU banks’ strategies and strategic developments and the other on outsourcing by EU banks.

The contents of the report can be summarised as follows:

The main structural developments in the EU-15 continue to be the consolidation within and across borders as well as sectors (albeit at a slower pace than a few years ago), the focus on domestic retail business, high integration and internationalisation, and the rise in direct market sources of finance due to generally favourable market conditions.

Banking sectors in the new Member States are rapidly catching up with their counterparts in the EU-15, not least because of the high degree of foreign ownership, mainly from EU-15 countries. Banking sectors in the new Member States are generally also very highly concentrated, although competitive pressures remain high. The retail sector has witnessed rapid growth during 2003 and early 2004.

A survey of EU banks’ strategies and strategic developments conducted in early 2004 shows that mainly EU-15 banks attached relatively low importance to strategic risks and a relatively high importance to macroeconomic and operational risks. However, over the longer term, strategic risk can outweigh macroeconomic and operational risk and may affect the long-term performance of banks. Looking ahead, banks surveyed identified consolidation, an adaptation of the organisational structure and regulatory initiatives (e.g. Basel II) as potentially significant drivers of change.

Outsourcing is becoming increasingly widespread in many fields of EU banks’ activities and is mainly driven by cost reduction motives. Typically, support and back-office activities are outsourced, while core activities still remain within the bank. Although most banks were satisfied with the business consequences of outsourcing, some banks pointed to negative experiences, such as high costs and deterioration in service quality levels. Finally, potential financial stability concerns may arise, particularly where the outsourcing of important activities by financial institutions is concentrated within the same providers.

Both documents can be downloaded from the “Publications” section of the ECB’s website (http://www.ecb.europa.eu/pub). Printed copies are also available free of charge from the ECB’s Press and Information Division at the address given below.