Best Banks Barely Cover Capital Cost Europe Study

Scandinavia’s biggest banks, which rank highest in a Bain & Co. a study comparing returns on risk-weighted assets, are still hardly making enough money to cover the cost of holding capital.

Nordic banks had an average return on risk-weighted assets of 1.9 percent in 2012, the highest ratio in western Europe, according to Bain’s calculations. For European banks, the average was 0.5 percent last year and zero in 2008, the report showed. Swedbank AB and Svenska Handelsbanken AB, both based in Stockholm, had the highest returns among western Europe’s biggest banks, at 4 percent and 3.6 percent, respectively.

“One tends to say that the Nordic banks are doing so great right now, because they are so much better than Europe,” Lars Jacob Boe, a partner at Bain’s Oslo office, said in a telephone interview on Aug. 21. “But if you look at 1.9 percent on risk-weighted assets, it’s still just barely making cost-of-capital, and all the banks have ambitions to earn cost-of-capital-plus.”

Though the study is yet another example of Swedish banks outperforming their peers, it also suggests the rest of Europe’s financial industry is poised to catch up, according to Boe. The 44-member Bloomberg index of European banks has gained 12 percent this year, after soaring 23 percent in 2012, signaling investors are hoping for improving returns as the euro area surfaces from its debt crisis.

‘Value Destruction’

“It’s very difficult to see European banks continuing to have returns significantly below cost of equity over time,” Boe said. “These returns represent value destruction and it would be unprecedented if this is allowed to continue over a long period.”

Europe’s biggest banks have stepped up efforts to shrink risk-weighted assets, improving their chances of boosting returns. Deutsche Bank AG, continental Europe’s biggest bank, said in July it plans to reduce its balance sheet by 250 billion euros ($334 billion).

France’s three largest banks -- BNP Paribas SA, Societe General SA and Credit Agricole SA -- last year cut risk-weighted assets by a combined 128 billion euros and shed thousands of investment-banking jobs to comply with stricter international capital and liquidity requirements.

“It represents a big, big challenge to fix the European banking system,” Boe said. “There is a lot of restructuring work ahead, but fundamentally you must believe that it will happen.”

Riskiest Assets

Banks in Sweden have done better than their European rivals because they’ve already shed the riskiest assets from their balance sheets, Boe said. The lenders, which have been working toward a deadline this year to meet a 15 percent risk-weight requirement on their mortgage assets -- as much as three times the level they were using previously -- have put behind them property bubbles that ripped through the Baltics in 2009.

The rapid economic adjustment in Latvia, Lithuania and Estonia helped Swedbank and SEB AB contain writedowns stemming from those operations by 2010. The Nordic banking crisis of the 1990s was also a “valuable lesson” for the region’s financial industry and helped put in place a regulatory framework that left Scandinavia better prepared for the market shocks that hit five years ago, Boe said.

“They built up robust risk management and credit processes that they quickly activated as the global financial crisis took hold in 2008 and after,” he said.

Financial Markets Minister Peter Norman said today Swedish lenders may face even tougher capital requirements as he unveiled a raft of proposals designed to counter bank industry risk.

Basel Floor

Nordea Bank AB, Handelsbanken, Swedbank and SEB must all hold at least 10 percent capital of risk-weighted assets from this year, with the minimum rising to 12 percent in two years. All four already exceed the 2015 requirements. The Basel Committee on Banking Supervision sets a 7 percent floor due to become effective by 2019.

Nordea, Scandinavia’s biggest bank and Europe’s No. 10 by market value, topped the ranking of Europe’s 10 largest banks with a return on risk-weighted assets of 1.9 percent. Swiss banks, including UBS AG and Credit Suisse AG, had an average return of only 0.1 percent while German lenders’ average return was 0.7 percent. BNP Paribas SA and HSBC Holdings Plc had positive returns of 1.6 percent and 1.8 percent, respectively.

Return on risk-weighted assets, or RoRWA, is one of the best metrics to measure a bank’s health, according to the Bain report. Its focus on the balance sheet helps it capture the interplay between the economy, capital adequacy and asset quality, Bain argues.

Aggressive Growth

Using RoRWA, the assumption is that “European banks will probably increase even faster and more than the Nordic banks, because the Nordic banks are already at the cost of equity,” Boe said. “Relatively speaking, I believe that return on equity is going to increase more in Europe in the next five to 10 years than in the Nordics. However, one must remember that Europe starts from a very low base.”

Meanwhile the Nordic region has yet to deal with record private debt burdens and inflated house prices, Boe said.

“It has been a market almost without losses for the banks in the past 10 years, but banks have grown aggressively in this market to capture customers,” he said. “There is risk that there is a real estate bubble in the making. Interest rate increases of just a few percentage points could trigger a reversal of the trend with increasing real estate prices, and lead to bank losses and this could potentially also be an issue in Sweden, so the mortgage market is something to watch.”