2012 Retail Banking Radar: Change Looms in Europe
European retail banks are returning to normal levels of income, costs, and profitability. The not-so-good news is that those unprepared for the next round of challenges will struggle to survive.
Since bottoming outin2009, Europe's retail banks are continuing to recover (see figure 1). Income remained remarkably stable even during the worst of the economic crisis and is just slightly below 2007 levels. With the exception of banks in three countries—Portugal, Spain, and Italy—risk provisions have also rebounded, yet profits remain nearly 15 percent below pre-crisis levels. On the cost side, most banks have refrained from adopting substantial measures to reduce costs, choosing instead to focus on cost containment, which likely explains the fairly stable cost-to-income ratios of the past few years. The Nordic banks have more recently paid more attention to digital transformation and cost containment which explains their better numbers.
These are among the main findings in A.T. Kearney's 2012 Retail Banking Radar, an annual Index that monitors the dynamics and challenges in the European bank industry (see sidebar: About the Study). While the findings point to some level of optimism, Europe's banking environment continues to be volatile and will require retail banks to be prepared for more fundamental changes.
This paper highlights the major findings. We begin with a look at Europe's current retail bank industry, identify some of the country-to-country differences, and highlight reasons for the shaky start endured earlier this year. Finally, noting that challenges and opportunities are never far removed, we discuss the future of the industry, including new business opportunities for retail banks to consider—opportunities that so far have been largely ignored.
A Look Back—and Into the Probable Future
The market from 2007 to 2011 is instructive in understanding Europe's current retail-banking industry—and sets the stage for a glimpse into its probable future. Following are some of the main market characteristics, derived from our study of a number of factors, including the ability to realize customer potential, employee productivity levels, cost base management, quality in terms of risk provisioning, and main sources of income (see figure 2):
Income per customer and income per employee
Remarkably, retail banks have managed to maintain a stable top line in this poor interest margin environment. Even in 2009, income per customer was €651, down only 4 percent from 2007's €675 and has since come nearly all the way back to reach €670. Income per employee is even slightly above 2007 levels (€199,000 compared with €198,000), a sign that costs are being managed. Overall, banks seem to have found other revenue sources to compensate for a loss of trading activity and higher-margin investment products. The overall average, however, conceals the fact that banks in several countries—Italy, Portugal, Spain, and the United Kingdom, most notably—saw their income levels shrink. In Switzerland and France, meanwhile, income per customer is up by about 10 percent.
Interest income relative to total income
Much has been made of the importance of more traditional—and supposedly stable—post-crisis banking business models. This typically translates to more on-balance-sheet products and lower loan-to-deposit ratios. Our data indeed reveals an increase in interest income, compared to commissions and other income, to a level previously only held by Austrian, Benelux, and Spanish banks. Interest now accounts for at least two-thirds of retail-banking income, up from 60 percent in 2007.
Such a mix, however, will not allow for big jumps in income. A low interest rate environment is a challenge for European retail banks. Over the past two decades, interest margins have plunged to half their previous levels. Simply put, it is difficult to make 2 percent margins if one-year deposits are paid at 1 to 2 percent and mortgage loans for similar periods are charged a 3 percent interest rate, as is currently the case. Naturally, each institution applies its own blend of funding sources and lending products, and the maturity mix and "treasury curves" will differ. The general outlook for this area is hazy. The Economist Intelligence Unit expects interest margins in Western Europe to remain at an abysmal 1percent over the next five years, and in Eastern Europe to drop from 2.6 to 2.2 percent (see figure 3).
On the surface it appears that banks have kept their operational and administrative expenses well in line with the somewhat volatile income scenario. Average retail-banking cost-income ratios increased from 60 percent in 2007 to only 62 percent in 2008 and came back to 60 percent in 2011. A more detailed country-to-country look, however, reveals a convergence of cost-income ratio levels. While the difference between the worst and best country amounted to 32 percentage points in 2007, it came down to 24 percent in 2011. This means that banks in only a few markets— particularly France and the Benelux countries—improved their cost-income ratios, while others—Italy, Portugal, and the United Kingdom to name three—dropped in operational efficiency.
The overall stability in cost-income ratios indicates that banks have effectively managed their cost base in line with the income development. But it also indicates that they have shied away from a more fundamental redesign of both their business and operating models—that is, they have yet to prepare for higher levels of risk and cost (for example, through equity requirements) that await.
Risk provision relative to total income
The level of risk provisions rose to 13 percent in 2011, below the 2009 peak of 17.5 percentage points above normal provisioning levels. Still, we believe a cautionary note is in order: Although this area has improved in many markets, some southern European markets have not done so well. Given the material re-evaluation of debtors' creditworthiness and stricter regulatory demands, we believe it prudent to plan foran elevated level of risk provisioning going forward.
Profit per customer
As a consequence of the above factors, profits decreased by almost 25 percent between 2007 and 2009, and remain nearly 15 percent below 2007 levels. While European banks earned €205 per customer in 2007, they generated just €171 per customer in 2011. There are big differences between countries, however. While Portuguese banks have given up practically all of their profits and Spanish banks have suffered almost as much, banks in Austria, France, and the Benelux countries increased their profits by as much as 18 percent.
When we de-average European retail banking development, a split picture appears. While banks throughout Europe suffered during the 2008 financial crisis, all but those in Italy, Spain, and Portugal have shown signs of recovery over the past two years. The picture in these three countries reveals a sovereign debt crisis in the profit-and-loss statements of retail banks as risk provisions continue their steady rise.
At the same time, structural differences among European retail-banking markets persist, and reflect both key strengths in currently battered markets on per-customer income (Italy, for instance) and structural weaknesses of allegedly stable markets in income realization and cost management (France and Austria are good examples). In an analysis of country-to-country differences within the dimensions of the Index it is clear that averages tell only part of the story. Income realization spreads between around €300 and €1,200 per customer, risk provisions range from around 7 percent to more than 30 percent of income, and profits range from nearly zero to almost €400 per customer (see figure 4).
The Index reveals a clear pattern:
- Banks in Switzerland and the Nordic countries rank high in most dimensions on the Index. Swiss banks excel in income per customer—despite average cost-to-income ratios they earn the highest profits per customer of all banks in the Index. Banks in the Nordic countries enjoy the highest income per employee and lowest cost-to-income ratios.
- French and Benelux banks lead the middle-ranking group in European retail banking. Italian and Spanish banks have attempted to keep up, but are thwarted by negative performance in managing risk.
- Portuguese banks occupy last place in several dimensions, including a business mix that appears to be getting increasingly unbalanced and losing interest income.
Following are a few more factors revealed by our 2012 Index:
Customers, cards, and other profitable possibilities
The wide range of income per customer across the European markets indicates significant future potential for banks in some countries (see figure 5). Italian banks managed to realize almost €950 per retail banking customer—a figure surpassed only by the strong Swiss banks—while French and Benelux banks generated about 700 Euros per customer. There are various reasons for these numbers and the more modest tallies of banks in Germany, the United Kingdom, and Portugal at the other end of the spectrum. We believe that these differences point to the potential for lagging banks to implement more profitable services and products—cards and payments (e-commerce), for instance—or profit from long-term savings, not to forget about different pricing policies.
Business mix matters
Across the board, the contribution of interest income has become more important for European retail banks. Banks in two countries are worth mentioning: French banks are seeing the highest increases and as a result are relying more on interest income—actually reverting their unusual business mix from about 45 percent interest to close to 60 percent interest income over the past five years. Their mix now resembles that of most other European markets. Meanwhile, Portuguese banks have lost interest income to the extent that its share has been shrinking significantly with banks now relying more on commission income than on interest income (see figure 6).
Two crises—the 2008 banking crisis and the 2011 economic and sovereign crisis—are apparent in the trend in risk provisioning. While risk provisions have been rising steadily at about 12 percent overall since 2007, a clustered view shows a more differentiated picture. In nearly all markets, risk-provisioning levels have shrunk for the second consecutive year to half their peak 2009 levels. The exceptions are Italy, Spain, and Portugal, where risk provisions have tripled compared with their pre-crisis levels (see figure 7).
Profitability ... still elusive for many
Across Europe, profits per customer have been rebounding after hitting bottom in 2009. Spain and Portugal were very robust when the 2008 crisis took hold, but have plummeted since 2009. On average, Portuguese banks in our Index made no profit on a retail banking customer in 2011, and Spanish banks are nearly as woeful. There are numerous reasons for the poor performance in this dimension—from the contraction of local economies to risk provisions and impairments—but the situation indicates that the economic and sovereign crisis is having serious effects on both countries' retail bank sectors (see figure 8). The restructurings and recapitalizations of banking sectors in both Portugal and Spain are a reflection of this second crisis.
2012's Slow Start
Having established some background, let's look at the current situation and peer into the future. As in recent years, comparably positive drivers were in play at the start of 2012. In December 2011 and March 2012, the European Central Bank provided significant funding at favorable terms through its two "long-term refinancing operations." At the same time, stock markets picked up, providing long-awaited relief to retail banking's battered investment businesses. But in addition to lingering doubts over the sovereign situation in Europe, several factors have made it difficult for retail banks to benefit from these positive developments:
- Investor sentiment. Commission income decreased as investors, reluctant to trade despite rising stock markets, turned to deposit products.
- On-balance-sheet business. Deposits rose as investors—and banks—moved to on-balance- sheet products and funding. This helped overcome margin pressures and stabilize interest income despite a decrease in new loan production at many banks during the first quarter.
- Risk management. Banks keep a close eye on risk provisioning and coverage ratios. The level of risk provisioning is mixed, with some banks reducing and others increasing on a year-on- year basis. This is likely to continue.
- Cost management. All banks claim to focus on strict cost controls, IT cost reductions, and improving cost efficiencies. The truth is that with very few exceptions, costs are barely being contained or are increasing—which is leading to worsening cost-to-income ratios.
As mentioned earlier, year-on-year profits have fallen for retail banks in most of Europe. The exception is the Nordic countries where banks have embarked on ambitious initiatives in cost-to- income improvements and digital transformation. Not only are these banks cutting costs, but also changing the way they deliver their offerings—from cashless branches and mobile banking to revamped online advice and services—to meet the demands of their modern, mobile, and increasingly tech-savvy clientele.
For Europe's retail banks, challenges and opportunities are closely linked. As our Retail Banking Radar 2012 indicates, there is a continuing need to be wary of market developments and stresses, and to capitalize on new business opportunities that for now continue to be mostly ignored. Several areas need attention:
An abundance of opportunities exists in consolidating, cooperating, and improving operational excellence. Cost-income ratios are still significant and all organizational levers—process, IT, smart sourcing, skills, and capacity management—need improvement.
Stressful times have an upside: They provide an excellent opportunity to discard legacy burdens ranging from products and sales structures to processes and IT. For example, in our work with retail banks, we have been able to help streamline product portfolios by as much as 35 percent. It is important, however, to separate the "good" complexity from the "bad" to maintain focus on those areas of the business that generate the most value.
Banks are notoriously poor performers in establishing prices and pricing strategies. Many services are provided without charge and many banks have the mistaken belief that basic services (current accounts) should be free of charge. This is fine if lost income in one area is made up for in another area, but four times out of five it is not. Also, there is a tendency to undercharge customers and concede rebates and special conditions without stringent pricing management. Pricing is not a short-term fix but rather requires a structural and cultural transformation.
Any industry facing commoditization—as banks are in account management, payments, and mortgages—typically looks for more innovative ways to provide services to their customers. As bank products become "frequency generators," similar to what we see in supermarkets and telecommunications, the treasured business models—payments, for example—are being threatened. The solution is often found in innovation. For example, offering mobile banking is a good way to retain loyal customers.
It is vital to nurture primary relationships with high-value customers while containing or reducing interaction costs with low-value customers. This requires a thorough understanding of customer potential, whether in retail or in business banking, and developing more differentiated service models. The idea is to use a systematic approach to upgrade promising customers with offers of blue, silver, or gold status, which is the complete opposite of randomly discounting prices and offering free services to customers regardless of their potential value to the bank. Making a change such as this requires a shift in mindset. Rather than attracting more customers to the bank, the focus is on developing the better customers; this translates into more loyalty and lower service costs.
The next revolution in sales efficiency for retail banks is the move to a true multichannel, database-centric model. Here, the branch will no longer own the relationship but will become one channel among many channels, playing a role for certain services and customers, especially the increasingly tech-savvy customers who want more sophisticated banking services. In the next two to three years, we expect larger banks to completely revamp their sales structures to become multi-channel. Activities will revolve around the rapidly evolving technologies for data storage, analytics, communication, and end-customer devices such as mobile. Changing over to digital delivery models—and thus reducing operating expenses—will be key to creating resilient retail banking models in the years ahead.
Time to Branch Out
In conclusion, while the 2012 Retail Banking Radar findings indicate a certain amount of optimism, Europe's banking environment continues to be volatile, and the banks within that environment are neglecting a number of important areas. The retail banks that batten down in hopes of weathering all future storms are, however, likely to suffer severe damage or worse. The banks that stay afloat and flourish will be those that are not only prepared for more radical changes but are ready to make radical changes. This will entail crossing the divide from the branch-centric model to a customer-centric one, where bank clients can access services beyond opening hours on all kinds of channels—from mobile across video chat with advisors to social web and the ability to walk into and obtain service from any branch. In other words, they will be meeting expectations already embedded in the consumer mindset by forward-thinking companies in other industries—and even perhaps exceeding them.