Banks' profits under pressure in persistently low interest rate environment

A healthy banking sector contributes to financial stability and supports the economy. Healthy banks are continuously able to play their role within the financial system and have sufficient buffers to absorb losses. Profits play an important role in this respect, as they offer a first line of defence against negative shocks. However, tension can arise between banks’ pursuit of profit and their role in society. For example, profit maximisation for shareholders may come at the expense of the accessibility of payments and other financial services. In addition, in their pursuit of profitability, banks could be prepared to take greater risks than are socially desirable to maintain financial stability. This is one of the reasons why banks are subject to regulation and supervision.

Profitability of banks restored after the financial crisis

Following years of subdued profits of Dutch banks due to the financial crisis and the European sovereign debt crisis, bank profits rebounded from 2015 onwards (see Figure 1). The favourable economic conditions, which have limited credit losses, and the significant cost cuts made by banks are among the reasons for this recovery in profits. In 2020, the COVID-19 pandemic caused another sharp drop in profits. Although profitability recovered in 2021, low interest rates continue to weigh down on net interest income, which are the banks’ main source of income.

Based on a scenario analysis, we have estimated the future profitability of four major Dutch banks (ABN Amro, ING, Rabobank and De Volksbank). We examined the impact of the interest rate environment using two scenarios: one in which interest rates remain low for a prolonged period (“Low for longer”), and one in which interest rates rise (“Rising interest rates”). The impact of the scenarios is also partly determined by the banks' ability to cut costs and reduce their sensitivity to negative interest rates. Banks may try to reduce their reliance on interest income by providing more financial services that earn them compensation in the form of a fee or commission, for example. The scenarios are not predictions, but a long-term mechanical exercise. They do not take into account various other factors, such as the economic business cycle.

In the Low for longer scenario, banks' interest margins are squeezed further. If banks do not adjust, their average return on equity (RoE) will drop from the pre-COVID-19 level (7.8%) to below 5% (see Figure 2). In this scenario, banks can only maintain their RoE by making drastic adjustments.