To achieve long-term profitability, European banks must shake off their dependence on net interest income as several years of low and negative interest rates have threatened the viability of traditional business models, according to market observers.

As lenders brace for at least a few more years of sub-zero rates, thanks in part to the pressures exerted by the COVID-19 pandemic, they will be forced to review their primary source of income and consider a shift to other, more lucrative, cash streams. Otherwise, the persistent net interest income pressure will restrict revenue growth, harm banks' bottom lines and limit their ability to invest, making them less competitive and prone to taking on more risk.

Despite efforts to diversify, net interest income still accounted for 58.9% of European banks' total income at the end of 2020, European Banking Authority data shows. The EBA has warned that bank profitability is likely to remain very low amid continued net interest income and margin pressure, posing a risk to the long-term viability of many institutions.

Strong and diversified fee income, from areas such as capital markets, payments, insurance products, wealth management and trade finance, is one of the most effective tools to offset net interest income pressure, according to Elizabeth Rudman, head of the European financial institutions team at DBRS Morningstar. Shifting the balance toward fee income will not be easy, but some banks should be able to manage it within the next three to five years, she said.

Under pressure

The largest European banks have struggled to grow net interest income since the European Central Bank introduced negative rates in June 2014, S&P Global Market Intelligence data shows.

Net interest margins — which measure net interest income generated from loans against the interest banks pay to savings account and deposit holders — have been on the decline, with notable drops in 2019 and 2020.

While banks were able to somewhat mitigate the net interest income pressure through loan growth before COVID-19, this trend disappeared in the wake of the pandemic as a drop in consumer spending amid lockdowns led to a surge in deposits. In 2020, eurozone banks paid €8.5 billion to the ECB in negative interest charges, the highest-ever amount, data by German financial technology company Deposit Solutions shows.

Read more on the impact of negative rates here: Margin pressure could incite more risk-taking among banks

Zero or negative interest rates can have "a devastating impact" on banks' loan books over the long term as new low-rate loans replace the maturing better-priced ones, McKinsey said in its 2020 annual global banking review. Banks' current business models mean the negative effects can easily spread across all components of the balance sheet, it added.

Retail and corporate banking remain by far the biggest contributors to bank revenues, but these activities are sensitive to a zero-rate environment. On the other hand, fee-based businesses account for a much smaller share of the banking revenue pool but have made the banks that have them more resilient amid the pandemic, McKinsey said.

Swiss groups UBS Group AG and Credit Suisse AG were among the best-performing European banks last year thanks to their wealth management and investment banking units. Indeed, investment banking was key to the growth of many European groups in 2020, most notably Deutsche Bank AG, which posted its first annual profit in six years despite the pandemic and an ongoing restructuring.

Aggregate net fee and commission income was less than half of the total amount of net interest income at the largest European banks over the last five years, Market Intelligence data shows.

Mitigation can only go so far

So far, in order to offset net interest income pressure, banks have mostly used the ECB's targeted longer-term refinancing operations, or TLTRO, programs and charged negative rate on corporate and, more recently, retail deposits. These measures are not a panacea for the problem, however, and have only reduced, but not remedied, the impact, analysts said.

Total bank borrowing in the latest TLTRO III program reached €2.19 billion in June, while banks' excess liquidity since the beginning of COVID-19 has increased by roughly €2.4 billion, ABN Amro estimates. "Basically, the amount that has been borrowed through TLTRO is less than that parked at the ECB, so banks are losing money," Tom Kinmonth, fixed income strategist at ABN Amro, said in an interview.

Although many banks have started charging negative rates on retail deposits, the financial benefit remains limited for now and lowering deposit thresholds for negative charges cannot go on forever as banks must preserve market share.

"There are limits to how negative you can go [as] people would eventually take their cash out," Scope Ratings analyst Marco Troiano said in an interview. In Denmark and Germany, deposit thresholds for negative rates have already been cut to as little as €10,000 in some cases.

According to Scope, negative rate charges on retail deposits pose business, legal and reputational risks for banks. By avoiding interest costs now, they risk losing liquidity-rich customers for the future. "While this may not seem like a huge immediate loss, it would deprive the bank of revenue potential as well as future funding optionality," the rating agency said in a recent report.

Need for change

Retail banking is in flux as COVID-19 has accelerated existing long-term trends including the demise of branches and the shift toward digital offerings at scale, Strategy&, a unit of consulting firm PwC, said in its latest sector report.

"Retail banking is under a lot of pressure. People do not want to do the current accounts, the banks cannot charge negative rates to clients easily, so banks are leaving retail," Kinmonth said, pointing to HSBC Holdings PLC's recent sale in France and ING Groep NV's plan to exit Czech retail banking and review its French operations.

Banks must focus on optimizing product offerings and pricing, as well as seeking additional income from fees and commissions by redeploying deposits, said Andreas Pratz, partner at Strategy&. Branch rationalization to reduce costs, as well as increasing pressure for pan-European consolidation among retail banks are expected over the next few years, he said.

The longer-term viability of traditional business models primarily focused on retail and commercial banking is at risk, especially when it comes to smaller, regional banks, according to Troiano. Cost cuts, repricing and redeploying of assets are effective measures, "but the reality is that there are too many banks and not enough demand for everyone to be profitable," and therefore the sector is bound to shrink over the medium to long term, he said.