“Banks need to get back to a certain level of profitability”

The interview first appeared in Luxemburger Wort’s supplement Classement des Banques in June 2022 (interview by Nadia di Pillo).

Interest rates, regulation, fintechs: Jerry Grbic, CEO of ABBL, talks about the challenges facing Luxembourg banks right now

For many years, the banking sector explained to what extent the current context of low interest rates is eating away its margins. Paradoxically, now that the situation is starting to reverse, the atmosphere is not necessarily one of celebration. Why?

On the one hand, the European Central Bank’s rate hike announced for July should allow for an improvement in banks’ interest rate margin. But on the other hand, with high inflation and poor economic growth, a return to stagnation is possible. At this point, banks need to be much more cautious with their risk management in terms of granting loans; in other words less lending, but of higher quality. At the end of the day, even with better margins, this will not necessarily produce better results.

Is inflation spoiling the party?

Inflation has reached a high level worldwide and risks unsettling a large number of businesses. The most fragile are unlikely to be able to survive, and a certain number of non-performing loans will weigh heavily on banks’ balance sheets. The consequence will be that employees of these at-risk companies may lose their jobs, and could find themselves no longer able to pay their debts. So in the end, this situation does nothing for the banks. Even if we make a bit more in terms of interest margin, non-performing loans could limit banks’ earnings. There is a good reason why the European Central Bank’s general mandate is to ensure price stability and keep inflation at levels close to 2%.

After a strong 2021, what do you expect in 2022?

2021 was a good year but there were a lot of one-off effects at the level of the various entities on the marketplace, as well as the release of provisions following the COVID-19 pandemic. Over the last 15 years, banks’ balance sheets have changed; banks have made great efforts in terms of governance and equity, significantly increasing their capital. This has enabled them to be resilient in the face of stressful situations or severe economic crises. Within the context of the pandemic, banks lived up to expectations by supporting the national economy in the short term with specific COVID-19 loans and debt moratoriums, and in collaboration with the government by means of the guaranteed loans scheme. Using these tools, banks were able to help clients manage uncertainty relating to the health crisis, but consequently had to make large provisions over the course of 2021. As for 2022, with the war in Ukraine we are once again now in a situation of uncertainty. The war, which is now focusing on the east of the country, could last for a long time yet. Will the sanctions imposed on the Russian economy have the desired effect? Will oil production from OPEC member countries increase and curb inflation slightly? It is highly likely that banks will, within the framework of prudential management of their assets and capital, increase provisions again to cover the potential risks.

Precisely, how is the war in Ukraine affecting the banking sector?

Even though Luxembourg is a major financial centre, its banks do not have a lot of direct dealings with Russia. We are therefore not directly concerned. However, as an international financial hub, a lot of international transfers go through Luxembourg’s banks. With the economic sanctions imposed on Russia by the west, banks are required to check whether foreign fund transfers directly involve Russia, or whether a structure included on the sanctions list is a beneficial owner. For banks, this means that in-house, all compliance and “know your transaction” departments have a lot of work to do to meet their obligations. Furthermore, our national regulator, the CSSF, is making visits to the various banks to check how the implementation of sections is managed on a day-to-day basis.

How is this being done in practice?

The various banks have specific software, systems that control transfers, and the level of flexibility can be adjusted very easily. In the current situation, and when in doubt, banks err at the more restrictive level. In practice, this means more manual intervention to check transfers. To support our members, ABBL is in regular, proactive contact with the regulator, and has created a working group to collect questions and find answers. It must be said that all banks want to apply sanctions correctly and do not wish to inadvertently finance part of the war. Failure to comply with sanctions represents a real risk, particularly to a bank’s reputation, which is not negligible.

What are the other constraints facing the sector?

A major challenge that is becoming increasingly clear in our sector is Luxembourg’s ability to attract new talent to the region. Property prices are a real obstacle to addressing this major issue. If you employ a new graduate today, their annual salary will probably be higher in gross terms, but their net salary, after accommodation costs, transport, etc. is something else entirely, and it’s highly likely that they will decide to stay put or move to Paris, Frankfurt or Zurich rather than come to Luxembourg.

Don’t forget that all financial centres are currently on the lookout for talent. They are all in the process of reviewing what they offer in order to make themselves more attractive. In London, for example, a special programme has been launched to offer tax benefits for foreign talent for the first two years after moving to the UK. It is true that Luxembourg also has a certain number of advantages to offer, but these need to be promoted. A flexible working environment and working hours are important. The ability to work from home is also a new selection criterion for employees and applicants. Luxembourg’s bilateral agreements with neighbouring countries limit working from home to 19, 29 and 34 days a year for Germany, France and Belgium respectively for tax reasons. There is also the issue of social security: cross-border workers must sign up to the social security system in their country of residence if they work there for at least 25% of the time. Considering that a lot of companies are in agreement about allowing more working from home, bilateral agreements are not sufficient to meet the expectations of businesses and cross-border workers. This creates the risk of a loss of attractiveness to non-residents coming to work in Luxembourg. This is a major point for discussion with the government.

Do you think the European banking sector will continue to consolidate?

The current situation is that one fifth of banks in Luxembourg are unprofitable. This means that those businesses could potentially be sold or merged at any time. If we look at the pace of regulation, pressure remains very significant. Investment in this area has risen in terms of costs by around 16% a year in the last five years. So, the question that many banks are asking is: can we limit or reduce these costs by joining forces with another partner? These are discussions currently taking place. If you look at the cost/income ratio in Germany, which exceeds 75%, it seems clear that there will be restructuring, in particular buyouts of German banks by more competitive banking groups. This will have an indirect impact on our financial marketplace, as all these major banks are also represented in Luxembourg.

ABBL complains about excessive costs and regulations that are believed to put Luxembourg at risk. What is the reason for these concerns?

In 2019, the percentage of investment dedicated to regulation was 38%, which is huge! For small banks, the level is even above 50%. This money is invested in regulation, not in other innovative projects, and so you run the risk of losing profitability as a bank in the long run.

In the last 15 years, the Luxembourg banking sector has become less competitive. The cost/income ratio is currently 60%. While the trend is downwards in a lot of neighbouring countries, it is rising in Luxembourg. Five years ago, it was 53%. The challenge for banks is clear: if they become too uncompetitive, banks might say they could operate elsewhere to increase their profitability.

What solutions do you envisage?

Banks are starting to realise the strategic importance of forming partnerships with fintechs. This helps to support innovation and extend the scope of their services. In Luxembourg, we have regtechs and fintechs that specialise in regulation. They offer solutions that appeal to banks, allowing for example for the pooling of various costs that are the same for all banks. This makes it possible to reduce costs and increase speed in terms of compliance with regulations. We can imagine, for example, a public private partnership agreement developing a new product in this area. A change of this kind would be a hallmark of quality for Luxembourg. Here is one very concrete example: for a bank, it is essential on a business and regulatory level that you know your clients well. Banks could pool the KYC information required. A service of this kind could be an attractive way of lowering costs, in particular for companies working with several banks.

How would you describe relations between banks and the fintech sector in Luxembourg?

More than 200 fintechs are based in the country and this ecosystem is certainly one of Luxembourg’s greatest strengths. ABBL’s aim is to facilitate contact between fintechs and banks to create productive exchanges. I’m organising a meeting between CEOs and fintechs after the summer break to talk about new trends and support the development of new technologies within banks. I think that this is a very important factor: exchanges and meeting points are easier in Luxembourg than elsewhere.

The development of regtechs and fintechs adds an extra layer of flexibility to provide customised solutions tailored to individual needs. Behind this logic, the client won’t see the fintech’s name, as the label will remain that of the bank. Today, banks have very cumbersome but very stable IT systems. What is important to every client is that the banks they deal with in Luxembourg are well-established; this provides a lot of security. On the other hand, with APIs (dedicated applications), banks are able to add applications to their in-house system that make it possible to respond to clients’ requests and demands.

What other niche areas look promising for 2030?

Luxembourg has always been able to attract new business activities. Over the last few years, we have developed expertise in the area of payment services and we are potentially the next European hub for these service providers, which are also working with the major banks. We also have a large corporate banking business, which accounts for around a quarter of the activity in Luxembourg. These companies operate partly in Luxembourg, and to a large extent in other countries, making international transfers. This is a very significant area that is very promising for the future.

Finally, Luxembourg may play an important role within the framework of the capital markets union. At the heart of this EU project is the question of corporate financing. Luxembourg has long been developing considerable expertise in the area of international corporate financing. Luxembourg could play a major role in this, in particular by facilitating access to investment by banks, as well as by means of alternative structures such as funds.

How is green finance developing in Luxembourg and what are the risks for banks?

Banks in Luxembourg are getting serious about the green transition. They are building on three levels: application of ESG criteria internally, the financing they provide and the investments they make themselves. Banks are aware of the issue and supporting or respecting ESG criteria now seems a given. The most problematic thing is the transition to green finance. We know generally where we want to go, but the path to it is complicated. Currently, banks are not opposed to the European strategy, but there is the risk of being accused of greenwashing for the simple reason that the current European framework does not set any guidelines about implementing the various regulations.

The taxonomy, presented as the central element of the regulatory strategy for sustainable finance, is intended to provide greater cohesion and transparency...

The problem is that there are numerous different laws and directives and they are not synchronised. We talk a lot about taxonomy, SFDR (Sustainable Finance Disclosure Regulation) – that much is true. But there is also the CSDR (Corporate Sustainability Disclosure Regulation), the Benchmark Regulation, the European Green Bond Standard, the Corporate Sustainable Due Diligence Directive, and all the tier 2 laws. This makes things very complicated. Many also have different timescales and this hugely complicates the work that banks have to do. They need a clear overview of sustainable finance regulations in order to be able to move forwards in this regard.

Finally, what do you think is the biggest challenge banks will face in the next few years?

Despite the disparities between countries, everyone agrees that the European banking sector is more stable and more resilient than was in the past. Even though profitability has deteriorated, European banks generally have higher capitalisations and are less exposed to non-performing loans. That being said, we do not need to add extra layers of regulation that would weaken banks and further dent their margins. In today’s globalised economies, this loss of attractiveness puts the banking industry at risk. In the long term, we will eventually lack investors. This is a problem for banks, of course, but also for Europe as an economic and political power, as banking is not like other industries. The banking sector has a major role to play in financing the European economy and its major transitions, in particular the digital and green transitions. It also has a role to play in the reindustrialisation of Europe. That is why the solidity and performance of the banking sector are important in enabling the financial system to sustain investment and economic growth. Banks absolutely have to get back to a certain level of profitability and improve their operating and financial performance while also continuing to innovate, in particular in the field of technology.