Returns on equity of banks supervised by the ECB plateaued in the first three quarters of 2017 at an average 7.06%. Given what’s happened to the risk profile of the European banking industry since the financial crisis, though, single-digit returns offer a reasonable proposition. Investors should get comfortable with the status quo, says Sam Theodore, head of the banks team at Scope Ratings.

Here’s why: the solvency ratios of the significant institutions are rising. At Q3 2017, the total capital ratio of the ECB universe of banks was 80 basis points higher year-on-year at 17.98% while the fully phased-in leverage ratio rose 18 basis points over the same period to 5.17%. Meanwhile, the IMF notes that global systemically important banks added USD 1.04 trillion in capital between 2009 and 2016 to USD 3.73 trillion.

“As an investor, it is perfectly legitimate living with banks earning high single-digit ROEs when there is a reduced likelihood of unpleasant surprises, since business models and risk and prudential metrics are more sustainable and predictable,” Theodore adds.

“Generating significantly higher returns on capital bases that are multiples of their pre-crisis levels, during a long period of low rates, amid intense competition at a time when banks have de-risked their balance sheets and business models is just unrealistic.”

Six reasons why returns will remain constrained:

1. Savers in France, Germany and elsewhere in Europe sitting on large pools of savings have been battered by low rates for years. As rates start inching up, there will be huge political pressure on banks to increase savings rates.
    
2. The biggest chunk of European bank balance sheets consists of residential mortgages, predominantly fixed-rate or with multi-year resettable rates, so banks aren’t in a position to reset pricing.
    
3. Higher rates will create a drag effect as highly-leveraged borrowers fall into difficulty or distress. That includes certain sovereigns for whom financial conditions haven’t materially improved since the crisis.
    
4. Debt-challenged sovereigns will create an uncomfortable reality for some banks – despite policy efforts to dismantle the sovereign-bank nexus. Government bonds are a core component of the High-Quality Liquid Assets banks have to hold to meet Liquidity Coverage Ratios.
    
5. The policy focus on consolidation in an over-banked Europe should be directed instead to cutting costs by eliminating excess capacity. Banks will only achieve that by reducing staff, closing branches and eliminating obsolescent processes, which is unlikely to happen on the scale required.
    
6. Banks’ earning ability is likely to be constrained over the medium term by more secular issues. Competition will emerge from non-traditional players, including digital and fintech platforms and from entrants with strong global brands that are already moving into or considering financial services, such as Google, Apple, Facebook, Amazon and Microsoft.

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