Setting the scene: A surge of temporary profitability 

Before the COVID-19 pandemic, global interest rates remained historically low, as banks endured compressing net-interest margins that pressured profitability. However, in 2022, the European Central Bank (ECB) intervened to counter inflation by raising interest rates that increased Luxembourg banks' return on equity (ROE) by 2.6 percentage points between 2022 and 2023.

Although positive, these gains cannot be sustained. This is particularly true as deposit rates catch up, credit demand slows, and unrealized losses on fixed-income securities impact balance sheets. For long-term growth, banks must make structural changes that focus on internal efficiency and reinvest recent profits into technological innovation and process optimization.

Takeaway:

Rising interest rates have boosted profitability, seen below, but this has also been accompanied by increased operating expenses primarily related to staffing, information technology (IT), and compliance. 

The problematic shift: Rising costs and performance disparities

Macroeconomic conditions have led to higher operating costs. Since 2019, staff costs have risen by about 8% annually due to salary indexation and a need for more specialized employees to address regulatory requirements. IT expenses have also increased as banks modernize their IT applications/infrastructure and develop digital solutions.

Inflation has worsened borrowers' credit quality, increasing provisioning needs and reducing credit demand, thus threatening profitability. Operational inefficiencies only add to the problem.

However, it is the banks that manage costs, workforce, and revenue streams efficiently that have ended up as top performers with ROE above 10%. They achieved a 51% increase in net interest income from 2021 to 2023, as compared to 43% for others. In contrast, less profitable banks struggle with limited operational efficiency and smaller scale.

We have already begun to see the market consolidating as institutions aim for scale and efficiency through mergers and acquisitions (M&As).

Takeaway:

Banks must address rising costs with structural changes and technology. Top-performing banks are prioritizing cost management, diversified income streams, and customer-centric innovation.

Preparing for what lies ahead: An analysis of three scenarios

Three potential scenarios outline distinct challenges and opportunities shaping the sector’s trajectory.

In the baseline projection, banks face challenges as interest rates stabilize and operational costs continue to rise. Profitability declines as interest rate-driven gains dissipate, and net interest margins narrow, leading to a cost-to-income ratio increase. Return on equity declines industry-wide, highlighting the urgency of addressing structural inefficiencies. This scenario assumes only incremental operational improvements.

In the best-case scenario, banks proactively adopt transformative strategies to offset rising costs and declining revenues to maintain stable profitability. This includes capitalizing on emerging opportunities, like open banking and partnerships with fintech firms, to enhance their service offerings and customer experience.

In the worst-case scenario, rising costs and falling revenues severely undermine profitability. In this situation, the cost-to-income ratio rises sharply, while net income largely decreases. Without structural reforms, some institutions may face existential challenges, including the risk of market exits.

Takeaway:

Costs are expected to rise and revenue expected to fall, reducing return on equity and profitability, increasing cost-to-income ratio. 

From insights to action: Four needed transformations

Four types of transformations are needed for sustainable growth in the banking sector. Here is how they are currently playing out.

Strategic transformation

The Luxembourg banking sector is consolidating into larger and fewer actors, reducing from 128 banks in 2020 to 116 in 2025. Recent M&As highlight how banks are looking for external growth that benefits from scale. Looking to enhance productivity, efficiency and profitability, some banks are launching restructuring programs to review the legal structure and transform some entities into branches in addition to divesting non-core business activities, such as fund administration.
 

Business transformation

Banks are also expanding their products and services with new offerings around alternative investments, real estate and private equity, with others adding services like account and wealth aggregation. Some banks are considering partnerships and collaboration with asset management actors to offer specialized products and investment funds, while others focus on growing and underserved segments, like mass affluent.  Leading banks are conducting profitability analysis per client, per product and base their pricing models and discount policies on this.

As financial institutions look to streamline and automate manual processes like onboarding, Know Your Customer (KYC) and operations, resources can be reallocated to other value-added activities. Some institutions have outsourced tax and regulatory reporting while others are looking to further leverage synergies between business lines.
 

Technology and digital transformation

Banks are working on modernizing the technology of their infrastructure and applications, with large actors launching core banking transformation programs. Cloud technologies can increase scalability and flexibility, while artificial intelligence (AI) has the potential to transform operations and customer services for both private and retail banks. Financial institutions using AI can relieve back-office resources required for document data extraction and archiving, while also  enhancing client interactions and personalized targeting. Some institutions are putting AI to work in fraud detection models, while others are leveraging AI-powered chatbots to assist staff with internal process and procedures.
 

Human resources transformation

As the industry evolves, leading banks are aligning workforce roles with emerging needs in digital, data, and product design. To support this shift, some banks have launched reskilling programs and are utilizing workforce analytics to manage performance, anticipate attrition, and boost employee engagement. Attracting and retaining top talent also requires robust sourcing and development strategies. Aligning incentives, offering clear career progression, and investing in workforce development are key to sourcing the appropriate talent and maintaining an engaged, future-ready talent base capable of driving transformation and growth.

Takeaway:

These four transformations should be considered holistically. The leading banks are integrating business model redesign, operational efficiency, technology modernization, and workforce evolution into a cohesive, future-ready strategy. 

Benchmark before building your strategy

Before deciding which transformation to prioritize first, banks must first assess their competitive position in the market. Using a systematic, data-driven approach can help identify critical areas for improvement before diving into operational details. You should use up-to-date data and compare indicators with competitors and analyse them over time to track progress.

After the assessment, it is important to identify initiatives that address specific issues and align with trends, prioritizing benefits and feasibility. Define an action plan for each, detailing improvements, impacts, timelines, risks, and required resources. Then, use an impact/ease-of-implementation matrix to prioritize actions and create an implementation timeline.

It is crucial to have a performance management framework to review and monitor achievements and benefits. Leverage accurate and current data to stay abreast of industry trends and use structured benchmarks with actionable plans, adjusting as needed, to stay relevant over time.

Conclusion

The Luxembourg banking sector faces a pivotal moment. As the short-term gains from favorable macroeconomic shifts are threatened, banks’ long-term viability and competitiveness will require responsive transformation in strategy, business, technology, and talent. Complacency is the enemy of competition. It will be the informed decision-makers, who focus on innovation and efficiency that will remain, or emerge, as leaders in the industry.

Should you want support in benchmarking or beginning your bank’s transformation journey, we can help: Bankview: Banking benchmarking and competitive analysis