European regulators officially consider most banks in the eurozone stable, despite the timid economic growth and low interest rates in the currency area. According to stress tests by the European Banking Authority (EBA) on July 29, most banks in the eurozone have enough capital to face a new economic crisis. But not all the banks are in good health.
The stress tests come at a challenging time for the banking sectors of several EU members, which are dealing with the thorny issue of banks' low profitability. In the eurozone, banks have somewhat improved their profitability after a long period of low returns, but their recovery is still weak. The average return on equity (which basically measures how much profit banks generate with the money their shareholders have invested) for European banks was at around 5.8 percent in the first quarter of 2016. This was slightly better than the fourth quarter of 2015 (4.7 percent) but below the first quarter of 2015 (6.9 percent). In addition, European banks' return on equity remains below their cost of equity (the return shareholders can expect from their investment), estimated to be about 9 percent. This gap has persisted since the financial crisis started in 2008.
The weak profitability of European banks is the result of several factors. The European Central Bank has progressively reduced interest rates, hoping to encourage economic growth in the eurozone, as have other central banks, such as the Bank of England. But this is risky for commercial banks because it narrows the gap between what they pay for funding and what they charge for lending. If they pass their costs on to customers (that is, if they charge customers for holding their savings), customers could withdraw their money. But if the banks absorb the costs, their profits take a hit. A prolonged environment of low interest rates could actually make banks even less willing to lend. Naturally, the health of banks is also connected with the health of the economies in which they operate. Credit supply and demand have improved recently. However, as the United Kingdom's decision to leave the European Union creates political uncertainty across the Continent, economic growth in the United Kingdom and Europe will probably slow, which would hurt banking activities.
The stress tests confirmed that Europe's banking sector is still vulnerable in many ways. Many of these vulnerabilities, such as weak profitability and high rates of nonperforming loans, are a legacy of the financial crisis. Others, such as market volatility and pressure on certain banks, are connected to the new phase of uncertainty opened by the Brexit referendum. In the coming months, political risk and slowing economic activity will probably continue to create problems for banks in the European Union, regardless of what the stress tests say.