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R I S K A S S E S S M E N T O F T H E E U R O P E A N B A N K I N G S Y S T E M

9

More than one third of EU jurisdictions have

NPL ratios above 10%.

While there are signs

of potential improvements, asset quality is

still subdued compared to historical figures

and other regions. The NPL ratio improved to

5.4 % in the second half of 2016 from 6.5 % at

the end of 2014. There are still material dif-

ferences in asset quality across countries.

Further gradual improvements in asset qual-

ity are expected by banks and market ana-

lysts, but they will strongly depend on suc-

cessfully tackling the impediments of NPL

resolution.

Profitability remains a major challenge as

EU banks reported an aggregate weighted

average return on equity (RoE) of 5.7

%

as of

June 2016, down by more than 100 bp com-

pared to June 2015, albeit an improvement

compared to 2015 and 2014 end-of-year

data.

The decline in profitability was driven

by a drop of total operating income by 8.8 %.

In the same period, operating expenses de-

creased by 3.6 %. The level of returns and

efficiency as of June 2016 suggests that EU

banks are not yet on a path of full recovery

towards a sustainable level of profits. It re-

mains a source of concern in the EU banking

system. This is confirmed by the fact that RoE

remain below banks’ cost of equity (CoE).

Operational risks appear to be on the rise.

Information and communication technology

(ICT) risk is increasing whilst litigation and

conduct risk-related concerns remain.

As

banking operations increase their depend-

ence on IT platforms and telecommunica-

tion networks, concerns about connectivity

and outsourcing to third party providers have

increased in prominence. In particular, the

rising digitalisation of distribution channels

and ‘always-on’ expectations of customers is

putting pressure on systems to adapt. Cyber-

attacks are on the rise and banks are strug-

gling to demonstrate their ability to cope. In

this context, supervisors are focusing on ICT-

related risks including measures to fix rigid

and outdated legacy IT systems, IT resilience

and governance and outsourcing. The entry

of financial technology (FinTech) competitors

is also seen as a challenge and opportunity.

Banks expect compensation and redress

payments to remain high.

According to the

Risk Assessment Questionnaire (RAQ) for

banks, over 44 % of the respondents have

made compensation, litigation and simi-

lar payments of more than EUR 500 mil-

lion since the financial year 2007/08. Banks

themselves do not expect a decline in com-

pensation and redress payments in the

near term future. Next to these potentially

substantial litigation-related costs, lengthy

processes until cases of detrimental prac-

tices are settled add to uncertainties among

consumers and banks. Litigation risk is con-

sidered as one of the most important factors

negatively affecting current market senti-

ment for EU banks, together with regulatory

uncertainty about risk weights, according to

market analysts.

Challenges of NPLs, operational risks and

low profitability continue to impact investor

confidence in banks and impede the banking

sector’s ability to contribute to economic re-

covery.

Action on NPLs is needed, including

supervisory actions, structural reforms and

development of secondary markets, along

with ongoing supervisory assessment of

banks’ business model sustainability.