The battle for financial supremacy between Europe and the US has characterised much of the past century. In the aftermath of World War 1, the US financial sector flourished, taking the lead from Europe. The Great Depression of the 1930s then gave the Europeans an edge once more, but the 1950s and 60s precipitated the second rise of Wall Street. Since then, the two have jostled for power, and their respective banks are a reflection of this, with the Americans dominating investment banking while the Europeans (particularly the Swiss) held sway over wealth management. However, in the wake of the financial crisis, a noticeable chasm has opened up between the US banks and their European counterparts. This can partially be explained by the difference in the recovery of their real economies: since 2009, EU GDP growth has, on average, trailed US growth by 1.3 percentage points. The stronger rebound of the US economy is only part of the overall picture: restructuring, fines and regulation have dominated the headlines for the European banks, and this has been compounded by a lack of strategic vision among executives. By contrast, US banks have been assertive in focussing on key strengths, while disposing of non-core functions. The banks are engaged in Western-style showdown of sorts: right now, it’s the Wall Street cowboys that are winning.
A striking statistic epitomises this divergence of fortunes: in the five years to August of this year, Goldman Sachs, JP Morgan, Bank of America, Citigroup and Morgan Stanley have increased their combined market capitalisations by $254.6 billion while the same figure was $9.5 billion for Barclays, RBS, Credit Suisse, Deutsche Bank and UBS. Indeed, shares for the latter group had decreased on average by 17% over this period.
So, what’s driving this?
One defining factor is the ability to attract top talent: according to the FT, European bank chiefs are paid less than half the amount of those in the US. Where once European banks could poach top executives from competitors, they now struggle to do so. Pressure from shareholders, regulators and the public have driven down executive compensation and bonuses are limited to two times salary. In spite of this, European banks have higher unit labour costs, with 70% of income going to labour, 15 percentage points higher than in the US.
The superior financial performance of US banks has been more apparent over the last few years. The below graph shows relative co-movement of net income prior to Q3 of 2011, a point at which Europe’s sovereign debt crisis began to worsen considerably. Return on equity (ROE), a key measure of profitability, had recovered better for the likes of UBS, but fell into negative territory again in 2012. While external factors can account for some of the decrease in profitability, the fall in share of investment banking fees carries a great deal of weight: in 2008, the US share of fees was 45% while it was 40% in Europe. This year, the figures are 50% and 28% respectively. In equities as well, the US is eating into Europe’s market share: equities revenue for the four big US investment banks (excluding Morgan Stanley) rose 16% in Q3 this year, and fell 4% for the seven biggest European players. Fixed income is the only area in which Europe is holding its ground: UBS and Deutsche Bank outperformed the US banks in the first few months of 2015. However, the fixed income bias in Europe is somewhat of a curse: tougher regulatory capital requirements have had a more detrimental impact for these assets, and a recent Morgan Stanley/Oliver Wyman report found that fixed income flow products used 40% of the industry’s capital in 2014 but only generated 5-10% of profits.
Europe’s banks now face a Catch-22 scenario: they must either reduce Risk-Weighted Assets (RWAs) in line with regulatory requirements or increase capital.
The first option isn’t particularly appealing: corporate lending in Europe is more prevalent as capital markets are less developed than in US, so the structure of banks’ balance sheet tends to differ on each side of the Atlantic. Deleveraging would ultimately lead to lower Earnings per Share (EPS), and this is likely to feed into lower dividends over the medium term. Raising capital is a potential avenue for Europe’s banks, but the timing could be better: the Euro Stoxx European banks index is down this year, and those with emerging markets exposure, in particular, have struggled. Credit Suisse announced a $6.3 billion capital raising plan in October, and its share price has since fallen 6.4%. Having gone to shareholders for capital twice since 2013, Deutsche Bank is instead set to scrap its dividend policy and sell some of its assets, including the retail banking unit, Postbank. A final option for Europe’s banks is to issue debt which could be converted into equity in times of stress, but the success of each of these strategies will be dependent on their ability to convey a clear strategy to investors, something which has been lacking of late.
With zero interest rates set to be place in Europe for much longer than the US (bar the UK, potentially), European banks need to press ahead with restructuring plans, rather than procrastinate. Barclays were debating whether to scale back their investment banking division and focus on their traditional area of expertise in retail banking when they hired Jes Staley, former CEO of JP Morgan’s investment bank, as CEO last month. Sending these mixed signals won’t endear investors and will further advantage US banks, especially in a weak European economic environment. To reduce the problems of excess capacity and high costs, there is an argument for consolidation of some European banks’ IB divisions, but merger activity is likely to be superseded by more immediate considerations, most notably the capital requirements they now face. The future prospects of these banks are mixed, at best, and they must do more to keep pace with their US rivals.