On April 13th, 2016 the International Monetary Fund (IMF) published a review about the failing banking system in the Global Financial Stability Report.

According to the report, financial institutions in European countries are at risk if they remain utilising their current business models. Using these business models could result in a reduction of the global economy by nearly 4%.

In a statement IMF-economist José Viñals says that ‘banks will have to adapt to a reality that puts profitability under severe pressure’. The current reality is too challenging for banks and could gradually lead to a minimisation of the banking sphere if banks refuse to adjust their business models. To solve this problem accurately, rigorous adjustments to the banking system, stock market, interest rates and problematic loans are also fundamental.

Market turbulence

In 2016 the instability of the banking system was notably visible in Greek, Italian, Portuguese and German banks. According to Viñals the bank’s responses reflected how insufficiently the financial crisis was processed: up to today institutions face problematic loans on their balances.

On top of that, European financial institutions still endure difficulties implementing regulations and attracting foreign capital that can be used in times of crises to absorb losses.

Taken together, the mentioned problems lead to higher costs of bank funding. In turn this higher cost base has consequences for profitability. Currently only 60% of the banks utilise ‘adequate’ business models, as reported by IMF. A quarter will be ‘tested’ and thus 15% is in the danger zone.

Negative interest rates

Another phenomenon affecting commercial banks are negative interest rates, which can vary. There are a number of financial institutions that benefit from the stabilising effect of the policy of monetary authorities. However, this ‘stabilising’ effect has a counter effect: it decreases interest rate margins for banks, meaning that they are forced to offer lower lending rates to customers at short notice. In addition, this results in lower profit growth.

Problematic loans

IMF advises policymakers to not ignore the challenging problems. If the issues continue to be ignored, market turbulence will take place earlier and at a higher pace. ‘It’s essential to solve complications concerning problem loans’, says Viñals. ‘In order to do so, supervision is necessary as well as reforming the bankruptcy loan law and developing a ‘non-performing’ loans market’. Another issue that needs to be addressed is overcapacity in the banking sector. Finally, Viñals highly recommends completing The Banking Union and introducing a deposit organisation system.

Following up the mentioned advice could give the global economy a push in the right direction. In 5 years profit growth could rise with 1.7%. However, ignoring the troubling issues could result in less profit growth, stricter financial conditions and rising debt burdens.

This article has been translated. It was originally written by Marcel de Boer and published in Het Financieele Dagblad on April 13th 2016. Click here for the original article.