IMF/ By Will Kerry and Andrea Maechler :Banks Should Help, Not Hinder the Economy

Posted on October 20, 2014 by iMFdirect

By Will Kerry and Andrea Maechler 
Banks are struggling to overhaul the way they do business given new realities and new regulations adopted in the aftermath of the global financial crisis. While banks are generally stronger—they have more capital—they are less profitable, as measured by the return on equity. There are a number of reasons behind this, including: anemic net income at banks, particularly in the euro area; higher levels of equity; and banks taking fewer risks.
If they cannot change their business models, there is a risk that banks will not be able to provide enough credit to help the economy grow and recover.

We’ve looked into this issue in our latest Global Financial Stability Report because banks will have to adapt their business models so they can do what banks should do: lend money.
A previous blog looked at the consequences of another change in bank business models—the reduction in market-making—on financial market liquidity. 
Mind the profitability gap
Bank return on equity has fallen to a historically low level, excluding the height of the financial crisis.
As a result, 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 (see chart). This chart shows that while many euro area banks have a profitability gap, this problem is by no means isolated to Europe.

Re-pricing, re-allocating and retrenching 
In this new paradigm—with low profitability and new regulatory requirements—banks have responded in several ways, including by cutting costs, selling non-core businesses and running off portfolios. But banks have to do more to be in a position to build and maintain adequate capital buffers without taking excessive risks. A combination of three different strategies—re-pricing, re-allocating and retrenching—could be employed.
Although banks have already increased interest rates on loans since the start of the crisis, they may need to re-price loans further. However, banks with less market power will find this difficult, either because they are surrounded by competitors in better financial shape that do not need to re-price, or because they face competition from players in the capital markets who supply credit, like mutual funds.
Banks may also re-allocate capital towards activities that can generate higher returns. But this may entail taking greater risks, and banks may find that they have limited capacity to re-allocate assets before they bump-up against risk-weighted capital requirements. As a result, banks may retrench from some activities altogether.
Economic headwinds
This means that as banks try to transition to new business models their ability to supply credit to the economy could be limited, potentially creating a headwind for the economic recovery. In fact, the simulations in our latest report suggest that 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.
In contrast, even accounting for lower cyclical pressures on profits, 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 (see chart). This suggests that some of the 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 golden opportunity to clean-up banks, restructure weak institutions, and resolve nonviable banks.
This will ensure that the weaker banks do not distort competitive pressures, preventing the stronger banks from undertaking the necessary business model changes. Banks should also adopt a more transparent pricing model that better reflects the underlying risks they are taking.
Finally, regulators should consider whether barriers to nonbank credit supply could be lifted, though this should be accompanied by new tools to prevent the build-up of risks outside the banking sector.