After years spent clamping down on risky behavior at banks andpunishing them for past misdeeds, Europe's regulators have awokento a new worry: Lenders aren't making enough money.

Shrinking profitability has become a “concern for financialstability” because it may reduce banks' ability to recover fromshocks by generating capital or selling stock, Bank of EnglandGovernor Mark Carney said on Nov. 30. The week before, EuropeanCentral Bank (ECB) President Mario Draghi said profitability“remains a challenge to be addressed.”

The issue has come to the fore after Europe's banks endured yetanother trying year. Financial stocks tumbled from January to Julyon the back of escalated capital requirements, ultra-low interestrates, and Brexit worries, only to recoup some of those losses onspeculation Donald Trump's presidency may bring regulatoryrelief.

“Banks have a chronic profitability problem,” said AntonyJenkins, the former chief executive officer of Barclays Plc whowent on to found cloud-computing company 10X Future Technologies.“It's important that regulators and executives address it.”

Return on equity, a key measure of profitability, sank to 5.7percent at European Union banks as of June, a decline of more thana percentage point from a year earlier, according to the EuropeanBanking Authority. In Britain, Royal Bank of Scotland Group Plc,HSBC Holdings Plc, and Standard Chartered Plc all watered down orpushed back profit goals this year.

“We intend to look at exactly this issue: what are the factorsaffecting the profitability of banks, and what steps are theytaking in their current strategic plans” to improve returns and tomaintain resilience? Carney said. “In other words, are theyaccreting capital or are they gradually shedding capital, and whatdo they need to do?”

The Bank of England, in next year's stress tests, will examinewhether the industry can endure a prolonged period of low rates andweak growth, and how banks might alter their business models toboost returns and ensure their viability. The ECB, in itsfinancial stability review last month, said variations inprofitability across the EU suggest “some banks have considerableroom for improving operational efficiency,” either by cutting costson their own or merging.

While American banks have faced their own profitabilityconcerns, those have been eased by geopolitical events. The U.S.banks' trading arms were well-placed to harness the surge inactivity precipitated by Brexit, and Trump's election has sparkedhope of more fiscal stimulus to spur growth. Central banks inEurope have called for stimulus from their governments since thecrisis, with little result.

With less help from the broader economy, one way for Europeanregulators to help banks become more profitable “might be tofacilitate or encourage more consolidation,” HSBC Chairman DouglasFlint said in a Bloomberg Television interview. “If I were aregulator, the thing that protects the system more than anythingelse is the generation of capital, rather than the raising ofcapital when it's lost.”

A frustration for top bankers is that the profitabilityinvestors demand hasn't come down even after lenders piled uphundreds of billions more in loss-absorbing capital, closed riskytrading desks, and beefed up compliance and culture programs.

Banks' cost of equity—an estimate of the return on equity thatinvestors expect—is still around 10 percent, the same as before thefinancial crisis. On the flip side, lenders' returns on equity arelikely to remain stuck in single digits for some time.

“At the moment, banks are destroying shareholder value and willfind it harder to attract more equity,” said Nick Hill, managingdirector of banking at Moody's Investors Service. “The main lever abank can truly influence is the cost one, which is why we areseeing these relatively aggressive cost plans across the wholesector.”

Attracting Investors

Even those measures can only help so much. UniCredit SpA,Italy's largest bank, announced plans Tuesday to slash 14 percentof its workforce and shut almost a quarter of its branches inwestern Europe, while disposing of bad loans and raising 13 billioneuros from investors. Even after that overhaul, it foresees areturn on tangible equity of 9 percent in 2019.

Some executives, who've argued for years that shareholders mustaccept lower returns in exchange for a safer banking system, nowwant help reassuring investors. Central bankers should say whatthey consider an appropriate return on equity within thepost-crisis framework of capital requirements and rules they'vehelped put in place, said members of the executive committee at twoof Europe's largest firms. That would help re-base expectations forcost of equity, they said.

While asking regulators for public profitability targetswould've been almost unthinkable a decade ago, successive bankingCEOs have been unable to stem stock declines that have left firmstrading at a fraction of their worth on paper. With such lowvaluations, European banks may struggle to raise equity if hit byanother large fine, said the executives pushing the idea of areturn target, who asked not to be identified telling regulatorswhat to do. Profitability has become a prudential issue and shouldbe addressed by regulators, they said.

There's little evidence the idea will catch on. John Vickers,who as chairman of the 2011 Independent Commission on Banking wasthe chief architect of the post-crisis overhaul of the U.K.financial industry, called the notion that regulators shouldtell investors what return to expect “odd and unnatural.”

Others suggest rule makers should stay out of the way beforethey do more harm.

Natasha Sarin and Larry Summers, in a September paper titled ''Have Big Banks Gotten Safer?'' argued “that an overhang of likelyfuture regulatory actions” have paradoxically made banks riskierthan before the crisis because investors, unable to predict whatlenders will earn, were shunning them.

Low profitability concerns bondholders as well as shareholders.At a September conference hosted by Fitch Ratings Ltd., 47 percentof those present said earnings were the main risk for creditors ofwestern European banks, outstripping the more headline-grabbingissue of Brexit, which got only 4 percent of votes.

Unhealthy Disparity

Bank CEOs have become increasingly frank about how they'reperceived. Credit Suisse Group AG's Tidjane Thiam, at a Bloombergconference in London on Sept. 28, suggested the gap betweeninvestors' expectations and lenders' returns “makes banks notreally investable as a sector.”

Jon Cunliffe, the BOE deputy governor for financial stability,has said he's investigating the disparity between investors'demands for earnings and what the industry can generate in thepost-crisis world. It's an issue that needs to be resolved, for thehealth of the financial system.

“An unprofitable banking system can't absorb shocks, and you'reasking shareholders to put money into a model they don't actuallythink generates the capital return that they require,” HSBC's Flintsaid. “Therefore, there's more likelihood of losses being forcedonto debt holders or ultimately some kind of public support.”

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