European Bank Returns Aren’t as Bad as You Think
The miserably low returns to shareholders reflect the banking system's lower leverage
Good news stories are few and far between for Europe’s bruised banking system, but there’s a little-noticed bright spot in recent bank earnings.
Banks’ return on assets — one measure of profitability — just reached a postcrisis high-water mark. The average return on assets for banks in the Euro Stoxx banking index was 0.34% in the first quarter. It touched that level in 2011 but has otherwise been below it since 2008. The median return on assets for those banks is even better, at 0.44%.
That’s still around 30% below the average level for the years immediately before the financial crisis. But it’s considerably better than returns on equity, which are still less than 50% of their pre-crash level.
ROA itself is rising because of three factors, according to the latest financial stability review from the European Central Bank: net interest income, writedowns of bad loans and non-interest income. Simply put, banks are making more money–somewhat surprisingly, given low and negative rates– and getting rid of bad assets that don’t generate much income.
They’re also making new loans, which adds to assets, but those loans are producing income that keeps the ratio from getting depressed.
It’s another story with return on equity. Despite higher returns, bank equity has been growing, thanks to a heavy push in Europe to raise capital.
For measuring profitability, it’s easy to see why ROE is the most relevant measure for shareholders, especially in the short term. Understandably, they want to know the profit they’re making on their investment most of all. But ROA is in some ways the more relevant figure for everyone else.
The last time ROA reached its current level was in 2011, around the time that European Central Bank hiked interest rates twice, and the bloc’s economy fell back into recession. ROA had declined to practically nothing by the middle of 2013, when the sluggish economic recovery began.
The gap between the two measures of returns is simple: leverage. Return on equity is net income divided by the amount of equity issued. A company that raises its debt levels can generate more income, lifting ROE with it.
Returns on assets, on the other hand, can’t be boosted by simply raising debt. The fact that ROA seems to have outperformed ROE in recent quarters can be explained by the lower leverage of European banks.
During the quarters before the financial crisis, total debt was regularly over 1,000% of total equity for Euro Stoxx banks. Over the last year, it’s fallen below 500%.
Because it can be increased simply by leveraging up, ROE is not always a good indicator of underlying profitability. During the 2002-2007 period, the ROA for European banks barely rose at all, according to the ECB, but higher leverage meant great returns for the owners of equity. Shareholders were predictably happy enough: the Euro Stoxx banks offered a total return of well over 200% from their 2002 low to their 2007 high.
The current divergence between ROE and ROA that seems to be opening up in Europe might also look familiar to American bankers. In the U.S, returns on assets are now 76% of what they were between 2004 and 2007, while returns on equity are just 56% of their former levels.
“Equity-holders often have risk-taking incentives out of line with the interests of other bank stakeholders, much less society” said Mr. Haldane, who is now the central bank’s chief economist.
To be sure, the return-on-asset data is not nearly enough for a bullish take on European banks. In the U.S, the banking recovery benefited from stronger economic growth than Europe is likely to see over the next few years. Earnings growth in Europe is expected to be weak, so there’s no promise that ROA will continue to grow at all.
Nonetheless, ROA presents a slightly less grim picture of the European banking system than ROE. The inability of the eurozone’s banks to return growing profits to their shareholders may be bad news for them, but if it’s because of less debt, it may not be a bad thing for Europe as a whole.
