“We have seen some actors [in retail banking] in Luxembourg provisioning quite a lot last year and reversing these provisions in [1H23],” said Dorian Rigaud, partner and banking and capital markets leader at EY, during the “Banking sector performance and priorities” presentation on 29 November 2023 at EY’s office in Kirchberg.

Retail bank earnings boosted by higher rates

On retail banks, EY noted an increase of 101% in net income in the first half of the year boosted by a rise of 34.2% in net interest margin, but also due to a large decline of 71.6% in the cost of risk on the back of the release of provisions. Rigaud explained that as these banks are cash rich, higher interest rates enabled them “to generate revenues based on these assets.”

Despite being a very large employer in the banking sector, the general administration costs for retail banks were up only 2%, which compared well to other type of banks in Luxembourg (all banks were up 4.9%).

Provisions have continued to be an issue for private banks

On private banks, Rigaud observed that net income increased by 65.4% over the same period, “driven almost exclusively” by net interest margin (+75.1%). Somehow surprisingly, he noted that provisions increased last year and continued to increase this year with the cost of risk rising by 20.3% in 1H23, but from a low level. He warned that it took place before the real estate difficulties that really started in June--therefore, late in the second quarter.

Rigaud noted that the staff costs have been relatively stable for private banks on the back of reduction in full-time equivalents (FTEs) and a tight control of payrolls, which at +2.97%, was below the rate indexation.  Yet they experienced a large increase in administration costs (+6.65%), which is +15% over the last two years, largely on the back of high IT expenses.

He is concerned about the decline of 1.1% in the “core” net commission, as private banks were “surfing the interest margin wave,” which started to decline in June. Rigaud expects the trend downward to continue over next year.

The good days for cost-to-income may be over

The support from higher rates has contributed to reducing the cost-to-income ratio to 40.7% in 1H23 for retail banks (from 51.4% in 2022) and to 60.6% for private banks (from 70.9%). He noted that three years ago, the levels were 80% and 90%, respectively, an outcome “driven by income.” Rigaud is concerned that the trend could reverse next year if costs are not contained or reduced.

The same view applies in the coming quarters for the return on equity, which improved to 7.6% in 1H23 for retail banks (from 4.1% in 2022) and to 13.5% for private banks (from 8.8%). Moreover, Rigaud expects non-performing loans to deteriorate already in the second half of 2023, adding further pressure on profitability.