Banks Should Help, Not Hinder the Economy

IMF Blog, October 20, 2014

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Authors: Will Kerry, Andrea M. Maechler
Date: October 20, 2014
Theme: Banks face a challenging transition after the global financial crisis—stronger capital positions but lower profitability—and may struggle to supply sufficient credit to support economic recovery.

Bank return on equity has fallen to a historically low level, excluding the height of the financial crisis.
Banks with 80% of the assets of the largest institutions have a profitability gap—their return on equity is less than the cost of equity (capital) demanded by shareholders.
The profitability gap affects many euro area banks, but it is not isolated to Europe.

Banks have taken steps including cutting costs, selling non-core businesses, and running off portfolios.
A combination of three strategies could be employed to build and maintain capital buffers without taking excessive risks:
- Re-pricing (further raising interest rates on loans where possible).
- Re-allocating (shifting capital toward higher-return activities).
- Retrenching (withdrawing from some activities altogether).
Constraints and trade-offs:
- Banks with less market power may find re-pricing difficult due to competition from stronger banks and from capital market suppliers of credit (e.g., mutual funds).
- Re-allocation may entail greater risks and is constrained by risk-weighted capital requirements.
- These constraints may push banks to retrench from certain activities.

Transitioning to new business models could limit banks’ ability to supply credit, creating a headwind for economic recovery.
Simulations in the Global Financial Stability Report indicate:
- Out of a sample of 300 large, advanced economy banks, only 60 percent (by assets) are strong enough to deliver more than 5 percent credit growth without requiring a significant re-pricing of their loan books.
- Almost 40 percent of banks require shifting to new business models before being able to meet credit demand when the economy recovers.
- The share of banks needing significant changes to business models rises to 70 percent in the euro area.
Some economies that most need a recovery in lending may face particularly tough challenges in providing an adequate supply of credit.

Policymakers should ensure that bank balance sheets are up to the task of supporting the economic recovery.
In the euro area, the ECB’s Comprehensive Assessment is a key opportunity to:
- Clean-up banks.
- Restructure weak institutions.
- Resolve nonviable banks.
Ensure weaker banks do not distort competitive pressures that would prevent stronger banks from undertaking necessary business model changes.
Banks should adopt a more transparent pricing model that better reflects the underlying risks they are taking.
Regulators should consider whether barriers to nonbank credit supply could be lifted, accompanied by new tools to prevent the build-up of risks outside the banking sector.

Banks Should Help, Not Hinder the Economy — Will Kerry, Andrea M. Maechler, October 20, 2014.