Wide Angle Shot: ‘"Excess or shortfall" profits of Austrian banks?

The spectre of ‘excess profits’ of domestic banks has been brought into the public debate in recent weeks. Whereas not so long ago it was the energy companies that received negative media coverage due to the "unjustified" profits realized as a partial result of the Russian war of aggression in Ukraine and the related turmoil on energy markets, this time it is the banks within EU in general or in Austria that are facing demands for taxes on ‘excess profits’. We are not aiming to find an exact definition for (supposed) ‘excess profits’ in a market-based economy. However, a differentiated view and some critical quantification is possibly required in this area.

Austrian banks have reported very solid net profits in the last two years (2022, 2023), which were significantly higher than in previous years. Viewed in isolation, the (consolidated) nominal net profits of the domestic banking sector in recent years stand out at around EUR 10bn andEUR 14bn (2022 and 2023 respectively) compared to average banking sector profits at around EUR 5-6bn in the years 2015-2021. However, this simplified approach ignores the macroeconomic circumstances and developments not only at present, but also in the past. The return on equity (RoE) for domestic banks has risen to over 15% for the 2023 financial year, the highest reading since the 2008 financial crisis. However, with a RoE of around 15% banks only earn a certain premium over their cost of capital. In the long term, the average cost of equity (CoE) for European banks stands at 8-12%, while regulations and market conditions of recent years mean that this ratio is possibly more in the 10-12%. Not to forget that European banks were not able to earn their CoE for a long period of time.

The Austrian and European banking sector also achieved the latest pleasing results after an exceptionally long phase of zero and negative interest rates that lasted almost twelve years. From a longer-term perspective, it is obvious that both the European and the Austrian banking sector have not kept pace with US banks in terms of return on assets since the 2008 Global Financial Crisis. While the US banking sector was able to achieve a return on assets (RoA) of 0.87% in the years 2008 to 2023 (average), the European banking sector is in a much worse position with a value of 0.44% in the same period (Austria: 0.23%). RoA values of around 0.44% on average (or 0.23%) clearly show that some European/Austrian banks were unable to generate their cost of capital (CoE) in the long term.

The short-term view of the last two years of European banks' earnings also ignores the fact that supposed “benefits” of monetary policy in the US — such as currently elevated interest rates well above the euro rates — were passed on to the banking sector at all times. No special measures were taken to limit resulting profits. Similarly, the US banking sector did not have to deal with negative interest rates, while the period of low interest rates was shorter than in the euro area. Moreover, Quantitative Easing (QE) by the Federal Reserve has distorted the entire yield curve (in terms of benchmark capital market interest rates) less downwards than ECB did. The contrasting profitability trends of US and European banks are also well reflected in the divergent share price performance and market valuation of banks on both sides of the Atlantic. While the price/book value ratio of European and US banks was roughly at the same level up until the Global Financial Crisis, it has drifted almost constantly apart since then. In the US S&P Banks sub-index, the price/book ratio is currently around 2.2x vs. 0.8x in the Euro Stoxx Banks Index.

As far as the profits of domestic banks are concerned, the considerable share of the CEE region should not go unmentioned when analysing profitability (nominal profits, return on capital; on a long-term average just under 45% of the profits of domestic banks). On a long-term average, Austrian banks generated annualized profits of just under EUR 2.5bn in their CEE franchises. In 2022 and 2023, the regional CEE profits stood at around EUR 5bn. Bold key rate hikes in CEE to an average of just over 8% in response to the inflation crisis also played a key role here. Due to the fact that rate hike cycles kicked-off much earlier in many CEE countries than in the euro area, these banking sectors are ahead of the Austrian (Western European) banking sector in terms of the momentum of earnings and interest income. As a result and against the backdrop of expected (market) interest rate cuts, the net profits of the CEE subsidiaries of Austrian banks grew by ‘only’ 4.5 % in 2023 (in previous years, growth rates of 50% and 75% were recorded here). From this perspective and in light of the ECB's interest rate cuts, it is highly likes that 2023 should also have been the peak in earnings for Austrian and European banks in the current cycle.

However, the return on assets is more important than the nominal earnings figures. At 0.9% (2023), the return on assets (RoA) for purely Austrian business is well below the consolidated figure (incl. CEE) of 1.15% and therefore roughly on par with European competitors (0.86% for 2023). In this respect, from a pan-European perspective, we do not identify a significant ‘excess-profitability’ of Austrian banks. Moreover, there are special banking taxation measures in many CEE countries, as profit increases in CEE were in some cases even more drastic than in Western Europe. We would also argue that ultimately the focus should be on (relative) ratios such as RoA. Nominal bank profits of Austrian banks ‘in the billions of EUR’ are boosted by the inflation-driven development of nominal GDP (real GDP growth plus inflation). In this context it is worth noting that the Austrian GDP in nominal terms in 2023 is some 25% above the 2020 level.

Nevertheless, a certain ‘excess profitability’ of Austrian banks compared to long-term trends is undeniably recognizable for the last two years. In addition to nominal figures, this also applies from a broader perspective. In nominal terms, profits in the Austrian business were around EUR 4 and 8 bn in 2022 and 2023, compared to around EUR 3 bn in earlier ‘good years’. In addition, the profits of domestic banks in 2022 and 2023 were well above 2% of economic output (GDP). The long-term average of this ratio is around 1.2% (since 2008), with previous peaks (excluding the 2020s) at 1.7 to 1.8%. We see the development of profits in relation to (nominal) GDP as a reasonable indicator for identifying (supposed) ‘excess profits’ and also for the long-term view. In this context and taking the long-term view, it is important to emphasize: Deviations in banking sector profitability in relation to GDP from long-term averages (1.2%) were/are very asymmetrically distributed over time. That said downward profit deviations from the long-term average were significantly more pronounced than upward deviations over the last decade or so. Since 2008, there have been seven years with an average of -0.8 percentage points below the long-term profitability average and seven years with an average of 0.4 percentage points above the long-term GDP/profit trend. The years-long phase of negative/zero interest rates in Europe, which also meant that banks had to pay negative interest on their deposits with the central bank (ECB deposit facility) in some cases, had a negative impact on the overall profitability of Austrian banks in the 2010s. In addition, unlike in other European countries, the passing on of negative interest rates in the retail segment was not possible at all in Austria due to a judgement by the Supreme Court.

The long-term view on profits in the Austrian banking sector in relation to GDP clearly shows that the domestic banking sector had to digest long phases of ‘under-profits’ or adverse market conditions. Specifically speaking, the Austrian banking sector was posting profits in relation to GDP below the long-term trend for years from 2008 to 2014. In concrete numbers: Current alleged ‘excess profits’ are mirrored by ‘shortfalls’ of at least EUR 17 bn or more than 5% of average GDP over this period. In contrast, current ‘excess profits’ (2022/2023) compared to the long-term profit/GDP trend development ’only’ account for just over 3% of GDP or EUR 16 bn. In this context, it should also be emphasized that domestic banks have taken substantial measures to boost efficiency during more challenging times (partially accompanied by the phase of zero and negative interest rates). The latter are now showing their effect with the tailwind of the drastic ECB rate hikes. If the domestic banking sector were to generate similarly solid earnings this year as in 2022, even then the ‘excess profits’ in terms of banking sector profit in relation to GDP vs. the long-term trend would "just" amount to around 4.5% of GDP from 2022 to 2024. , Therefore, even another strong earnings year would still not compensate for the last decade of structural ‘underprofits’! It goes without saying that there was no public discussion about bank profits being too high or too low in the times of ‘under-profits’, as is currently the case.

A key driver for the solid results of the Austrian banking sector in recent years can be found in the structure of loan books. The sector's interest income in 2023 has risen significantly compared to the previous year (+30%). If a comparison is made with European competitors, significant growth rates in interest income can also be observed here, with the Austrian banking sector only standing out in 2023. In 2022, the aforementioned comparison between the Austrian banking sector and the top 30 EU banks shows an increase in interest income of 20% (top 30 EU) and 23% (AT). As was to be expected, the growth in interest income is leveling off significantly over time. The half-year results published up until to date by the largest Austrian banks show average growth in interest income in H1 24 of ‘only’ around 4.5% compared to H1 23 (some banks are already reporting a decline of interest income). The comparatively high proportion of variable-interest loans in the household sector (proportion of variable-interest housing loans 44 %), which is significantly higher than the European average (proportion: 19 %), plays an important role here. Ovrall, European banks tends to have a much lower average share of variable-rate retail loans (Austria vs. the euro area 54% vs. 22%). In the corporate client business, Austria's share of variable-rate loans is close to the euro average (Austria vs. the euro area: 77% vs. 84%). The interest rate gains on variable-rate loans are of course accompanied by the most drastic interest rate hike cycle in the ECB's history, which was hardly foreseeable. A cycle of interest rate hikes such as that experienced by the ECB in recent years was otherwise only seen in the 1970s. In this context, it should be emphasized that customers have benefited for years from the very low interest rates on variable-rate loans (with fixed-rate loans sometimes more attractive for banks in the short and medium term) and it now remains to be seen to what extent debt rescheduling or partial credit risks on variable-rate loans will materialize. In the long term, variable residental real estate interest rates in Austria (2014 to 2022) were ‘only’ 1.59% compared to just over 2% in the fixed-rate segment.

The recognizable increase in the profitability of domestic institutions has also strengthened the banks' capital ratios, although there have been moderate distributions to shareholders. As a result, the common equity tier 1 capital ratio of the domestic banking sector will be well above the EU average for the first time at the end of 2023 (Austria vs. euro area: 16.8% vs. 15.8%). In this respect, we do not recognize any excessive payouts to shareholders, while safe banks can only be in the interests of taxpayers and politics with a view to future challenges. In this context it is also worth noting that a solid banking sector can have a beneficial effect on the sovereign rating.

Drastically changing interest rate levels were not only passed on to customers on the lending side, but the deposit side (refinancing) has also moved significantly for Austrian banks. Data on interest rates for sight deposits of households shows that this was last stated by the ECB in June 2024 at 1.06% for Austria, ‘beaten’ only by Luxembourg. This figure puts Austria in second place within the EU and well above the EU figure of just under 0.4% at the same time. As far as the interest rate on sight deposits is concerned, this is clearly below the relevant key interest rates (ECB deposit facility). Historically, the former has also been well below the ECB deposit facility. The spread was only particularly narrow or negative in the years of low, zero and negative interest rates. Currently, the spread between the ECB deposit facility and the interest rate on sight deposits is around 269bp and is therefore slightly higher than in the years 2000 (around 200bp) to the financial crisis (around 100bp). However, the pace of interest rate hikes to combat inflation was also unprecedented in recent history. It should also be mentioned here that, in contrast to the times before the Global Financial Crisis, there is significantly more structural excess liquidity (currently around EUR 3,000 bn vs. EUR 1,750 bn before the pandemic, peaking at over EUR 4,700 bn in 2022) in the European banking sector. In this respect, banks' appetite for deposits is limited and this is depressing the “price” or interest rate — at least for sight deposits.

The interest rate on term deposits followed suit even more visibly, in some cases even generating a positive real interest rate. Since the start of the ECB's interest rate offer cycle in summer 2022, interest rates on household term deposits have risen from 0.35% at the time to just over 3%. As a result, the refinancing costs of domestic institutions for customer deposits have also increased noticeably.

Alleged ‘subsidies’ (TLTRO III funds) to the banking sector have also recently been highlighted in the domestic media. The aforementioned ‘targeted longer-term refinancing operations’ of ECB not only represented ‘cheap money’ or long-term refinancing for the banking sector, but were also largely earmarked for lending and thus represented a targeted anti-cyclical economic policy measure focussing on (corporate) lending. This proved to be a plus for the economy, especially during the coronavirus crisis and the subsequent recovery. The favorable central bank refinancing was then easily reduced in light of surprising changes in conditions, but was replaced by more expensive long-term capital market refinancing. Overall, the refinancing side of banks is often neglected in many analyses. The banks' market refinancing costs (deposits, borrowed capital) have risen significantly due to the higher interest rates. This is clearly illustrated by the example of senior bonds and their ‘costs’ on the capital market. The average interest rate or capital market yield on bank senior bonds was 0.53% in the years 2014-2021, and currently stands at 3.41% (average from 2022 to date).

A short-term view of banking sector profitability over one or two years contradicts the view of the entire economic cycle and the fact that banking business per se means maturity transformation over years and that profitability figures for individual years are not very meaningful. Accordingly, it is also necessary to take a look at other factors influencing future profitability. Many of these currently point to a recognizable weakening of profitability indicators in both the European and Austrian banking sector. These factors include the significant increase in refinancing costs, falling interest margins, rising credit risks and continued weak new lending business.

With regard to credit risks, this means, among other things, an increase in the default rates for loans (NPL ratio). Austria's banks reported an NPL ratio in the retail portfolios of 2.29% at the end of 2023, which therefore remains solid in a historical comparison. The picture is different in the corporate segment. A significant deterioration in credit quality was already evident there in 2023, with NPL ratios rising from 2.69% to 3.7% in the 2023 financial year. Measured by the change in NPL ratios in 2023, the Austrian banking sector is thus the worst performer within the EU. In light of the particularly weak economic development of the Austrian economy compared to the overall European economy and the current interest rate environment, a further deterioration in credit quality in the sector is also to be expected. With this in mind, the ‘deliberate slowdown’ of the economy as part of the fight against inflation and high interest rate policy is expected to lead to higher default rates and rising risk costs for the banking sector in the coming years. Accordingly, the focus should be on building up reserves and less on the taxation or subsequent ‘distribution’ of supposed ‘excess profits’.

The downturn in the residential real estate and property lending business, which is a major component of the portfolios (primarily retail; share: 70 %), is also having a negative impact on Austrian banks. Measured by the growth rates of new lending, this downturn is above the euro area average and is partly induced by national political measures/interventions (KIM-V, a fairly restrictive debtor-based credit extension regulation) as well as the interest rate level. A significant recovery in the property lending business is not expected in 2024 and 2025. Moreover, Austrian lenders are above-average exposed in the commercial property sector compared to other European countries, which has also seen a significant deterioration in the quality of portfolios since the start of the interest rate cycle. Most recently, the Austrian National Bank (OeNB) reported a total CRE exposure of around EUR 191bn at Austrian banks. While the NPL ratio for this segment was still around 1% for Austrian banks at the end of 2021, it rose to 3.3% at the end of 2023 (OeNB data).

In view of the weak credit growth in the context of a change in interest rate policy to curb inflation with particular effects in the domestic property lending and retail customer business, a particularly gloomy economic outlook in Austria plus a blatant weakness in overall economic investment, we believe that the focus should be on future challenges in the banking sector (keyword: risk costs, scope for future lending) rather than on the profits of the credit institutions in recent years. In this respect, we believe that an additional bank tax would be a poorly targeted pro-cyclical economic policy measure in an already adverse macroeconomic environment. Furthermore, even if the profits of domestic banks have increased significantly over the past two years, this has strengthened the sector's capital buffers in an anti-cyclical sense and made the sector as a whole more resilient.

The possible effects of a hastily introduced/discussed bank tax must also be taken into account, as developments in Italy have shown by way of example. Market turmoil following a hastily the announcement of a bank tax with the aim of flushing money into the state budget led to a rapid reformulation and dilution of the announced measures. Finally, the Italian banking sector was faced with the choice of either paying the tax to the tax authorities or building up additional capital reserves instead. A large majority of institutions opted for the latter, meaning that the revenue for the state was close to zero. The ‘damage’ to the banking sector should not be forgotten, as such actions deterred (capital market) investors. Moreover, the capital position of Italian banks was historically well below comparable ratios within the euro area. Only since the coronavirus pandemic have the capital ratios (CET1 ratio) been able to catch up with euro area levels, while possible even a mark-up is needed. Against the backdrop of the traditionally more ‘shaken’ banking sector in Italy (keyword: more elevated NPL ratios, high proportion of domestic sovereign bonds in the bank books), an increase of capital ratios was possible desirable and needed. However, this can also be achieved in other ways than through ‘new’ tax burdens for the sector. In this context it is important to emphasize that for the Austrian banking sector, based on the developments outlined above, we do not currently consider any political/regulatory interventions to strengthen the capital buffers to be necessary.