January 3, 2017    4 minute read

Banking In Europe: Too Many Players, Too Little Performance?

Time For A Cut-Down    January 3, 2017    4 minute read

Banking In Europe: Too Many Players, Too Little Performance?

There is no doubt that European banks have underperformed compared to their US counterparts in recent years. There are several reasons for this. European banks certainly operate in a more challenging environment, as the EU is only slowly recovering from the crisis, capital requirements are set at more prudent levels than in the US, and interest rates are at all-time lows.

However, besides these macro-factors, some argue that the industry’s large size is the main reason for its low profitability. This raises the question of whether Europe is overbanked.

The “Sick” Banks of Europe

The average return on equity (ROE) of Europe’s largest banks in 2015 was around 5.8% and therefore well below its cost of capital, which is said to average 9%. Since ROE is one of the key, if not the most important, determinants which investors use to make decisions, European bank shares have experienced tremendous downward pressure. The Stoxx Europe 600 Banks index, which tracks the performance of the European Banking sector, decreased by 6.99% over the past year.

In contrast, shares of US banks, as measured by the Dow Jones US Banks index, gained more than 22% over the same period. Most analysts have a rather dim outlook on the European banking sector and this poor performance is said to be likely to persist in the near future.

6.99% was the drop in the Stoxx Europe 600 Banks index over the last year

Furthermore, the perceived performance of financial institutions in Europe is weak, too. Not a day passes by without the coverage of negative trends within the sector: the funding issues of the Italian Monte dei Paschi di Siena, the restructuring of some of the large German institutions, or European banks losing market share against their US rivals, to name a few.

The Solution: Consolidation?

There seems to be a consensus that the number of banks in Europe is too large, and, therefore, some form of rationalisation is inevitable. This is particularly so in Europe, where the economy relies heavily on bank-based financing and fixed costs for banks are high, which delivers a strong argument for mergers.

By way of comparison, bank credit to GDP ratio in Europe stands at 274%, versus 83% in the US. It is no wonder that the European Commission is making huge efforts to establish its Capital Markets Union (CMU) in order to increase access to market-based financing. European institutions are certainly aware of this, and the ECB recently discussed the issue of too many banking institutions in Europe.

Empirical evidence on the benefits of consolidation is offered by the Herfindahl-Hirschman Index which regresses the cost-to-income ratio against the concentration of the banking sector. These two parameters seem to be negatively correlated, indicating that fewer (and potentially larger) banks in Europe would increase the efficiency of the sector.

It Might Not Happen

Even though consolidation seems to be a problem-solver for issues within the banking sector, the market environment is everything but favourable for mergers in the near future.

According to Xavier Musca, the deputy CEO of Credit Agricole, mergers are more likely to occur when banks are performing well and market conditions are favourable. As of now, that is not the case in Europe, and the outlook for 2017 does not offer much hope for a significant reversal.

Furthermore, one ought not to forget that cross-border transactions raise regulatory issues, and as banks become systemically more important, funding costs are likely to increase due to higher capital requirements. This again raises the question whether shareholder wealth can be increased through those transactions.

As long as this question can not be answered with a clear yes, and as long as confidence about potential merger gains remains low, a major wave of consolidation is unlikely to occur in the near future.

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