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Overpopulated Banking in Europe

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Ten years ago, banks on both sides of the Atlantic were struggling to survive the worst financial crisis since World War II. Today, American banks seem to have recovered well, even entered the “golden age of banking,” if we are to believe JPMorgan Chase CEO Jamie Dimon. By contrast, the overall profitability of their European competitors remains significantly lower. Banks in the United States have reinvented themselves and can look to a bright future, including overseas, while many lenders in the European Union are still struggling to extricate themselves from a decade-long recession – triggered, after all, on the American side.

Different landscapes

Various reasons can be evoked to explain this discrepancy. Crisis management is one. In Europe, the recapitalization of banks took years, whereas in the U.S., it occurred “in one big splurge,” as The Economist put it, notably with the support of the government’s Troubled Asset Relief Program (TARP). While many European banks kept dragging along their nonperforming loans, freshly “TARPed” American rivals could forget about theirs and get back to business as usual.

In addition, European banks have faced a less favorable macroeconomic environment over the past decade. Slower economic growth and prolonged zero interest rates have squeezed margins, not to mention the stress produced by the euro area’s unprecedented sovereign debt crisis, at its peak between 2009 and 2012.

Above all, a heavy regulatory burden is impairing some of the main functions of commercial banks in Europe, including that of lending to the economy. Instead of being able to focus fully on clients, banks devote a substantial part of their energy to adjust to complex, costly and fast-changing regulatory compliance requirements.

Interestingly, EU banking authorities have their own explanation of the European banking sector’s declining profitability. The problem is not overregulation, they say, but “overbanking.”

Draghi’s diagnosis

Two aspects of this problem are usually put forth. First, as stated by European Central Bank President Mario Draghi, Europe simply has too many banks.

Some member states seem to be more concerned about this claim than others. Germany – a country whose low profitability of banks stands out in Europe – still has some 1,600 banks, though the number has dropped by 52 percent since 1995. Many of these lenders are burdened by oversized branch networks that require large and costly workforces.

Such “overcapacity” undermines efficiency and creates weaknesses in the banking sector, Mr. Draghi insists. Intense competition for meager profits tends to exacerbate the financial system’s propensity toward “boom and bust.” Banks under these pressures are less able to build up capital buffers and more inclined to take excessive risks to prop up the bottom line.

Chart showing decline in number of EU credit institutions
The EU’s banking sector has been shrinking for a decade.

Second, as ECB officials have observed, there is too much banking. Traditionally, financial flows in Europe involve a much higher proportion of banking intermediation than in the U.S. While bank loans are the largest source of finance to the European economy, capital market instruments (such as equities and securities) are an often-used funding alternative for U.S. borrowers.

A slight shift from banking to capital markets can be observed in Europe, yet it remains too slow in the eyes of EU policymakers. Overreliance on banking is generally considered detrimental to the eurozone’s capital markets, as Mr. Draghi noted in a 2016 speech to the European Systemic Risk Board (ESRB). The ECB president feared that the relative underdevelopment of Europe’s capital markets was hampering not only the completion of the Capital Markets Union, but also the ECB’s quantitative easing policy of corporate and government bond buying.

Medical protocol

Too much of a good thing” is how Daniele Nouy, the ECB’s top banking supervisor, sums up the situation. She chose chocolate as a metaphor for banking, reminding us that it is “a good thing in moderation, but too much of it can literally be nauseating.”

Mrs. Nouy continued by describing banking as the “economy’s vitamin B,” which if taken in excessive doses can harm both banks and the economy. One problem she cited is banking’s absorption of talents that could be useful in other sectors: “Just think of all the engineers and physicists who turned to building financial instruments when they could have been solving real-world problems.”

A medical analogy for an “overbanked” Europe had already been used in a 2014 report by the ESRB, an institution chaired by Mr. Draghi. In it, European banking was compared to an overweight patient. Regulators, like doctors, must follow a protocol, making a diagnosis (the patient is abnormally heavy) and tracing an “etiology” (how did the patient become overweight?) before prescribing one or more “therapies” – including, needless to say, losing weight.

Tipping point

In her calls for policy action to slim down a financial sector “grown too large,” Mrs. Nouy cited econometric studies exploring the relationship between finance and economic growth (from one she borrowed the title of her speech, “Too Much of a Good Thing”). She leaned heavily on a 2012 working paper from the International Monetary Fund (IMF), which contended that while financial development usually has a positive effect on growth, “there can be too much finance.” Beyond a given threshold, finance can impede economic expansion.

For policymakers, the difficulty is to identify when enough becomes too much. According to the IMF working paper, this happens when credit to the private sector reaches 100 percent of gross domestic product. By this yardstick, most of the global economy has suffered from excessive debt since the early 1990s.

The ESRB takes a more overtly political approach, arguing that the question of whether an economy is overbanked requires “a normative answer.”

This latter statement reveals much about the EU’s current line of reasoning. More than an empirically established fact (the European banking sector has actually shrunk by 26 percent since 2008, as Mrs. Nouy herself acknowledges), the overbanking argument allows the authorities to justify their push for an evolution that has already taken place in the U.S. during the postcrisis period: consolidating of the banking industry.

New prescription

The mantra among senior ECB officials, including Sabine Lautenschlaeger, vice-chair of the ECB’s Single Supervisory Mechanism (SSM) board, is that Europe needs fewer, but stronger and healthier banks with sustainable business models. This means to those officials that bank consolidation ought to be promoted on a policy level.

This goal can be achieved in two ways: 1) by letting weak banks (with inefficient or obsolete business models) fail and exit the market, perhaps assisted by the new resolution tools provided by the European Bank Recovery and Resolution Directive (BRRD) and (2) by encouraging mergers and acquisitions. In the latter case, cross-border mergers are clearly preferred over domestic operations, because, as Mrs. Nouy stresses, they “deepen integration.”

Chart showing decline in number of EU branch banks
EU branch banking has also wilted from electronic competition.

This call for more banking concentration contrasts with the EU’s usual position on competition issues. Most of the time, the authorities make every effort possible to “stop dominant companies using their power to drive out competition,” as Competition Commissioner Margrethe Vestager proudly told listeners last year at the American Enterprise Institute in Washington, D.C. More than half of the EU’s antitrust decisions over the past five years have been about preventing cartels, she said.

In the aftermath of the 2008 financial crisis, European banking regulators had long been reluctant to allow mergers creating megabanks, since the policy was all about avoiding financial monsters that are “too big to fail.”

Now, EU banking supervision is seemingly ready to charge off in the opposite direction. The new view is that scale is the key to long-term profitability and industry leadership. When endorsing failures and mergers, policymakers apparently no longer mind whether oligopolies come to rule the European banking sector.

ECB preferences

The goal of consolidation is to produce a “right-sized” banking sector that can “reliably serve the economy,” in Mrs. Nouy’s words.

This begs several questions beyond the obvious one about optimal size. How quickly does the industry need to be optimized? Which business models will be promoted, and which discouraged? Which lenders will be sacrificed and which supported? How big will banking conglomerates be allowed to get through mergers or acquisitions?

In June 2018, the Bruegel think tank in Brussels speculated that ECB supervisors would probably block mergers to create banking groups with assets greater than 2.5 trillion or 3 trillion euros. Still, this implies that very big entities are technically possible in Europe. Only a handful of global banks, all of them Chinese, have such prodigious balance sheets.

The American bank that comes closest is JPMorgan Chase, with total assets equivalent to some 2.22 trillion euros in 2017; the two largest European banking groups, HSBC and BNP Paribas, are close behind at 2.2 trillion and 1.96 trillion euros, respectively. Merging lenders of this size might thus be considered “too much of a good thing” by European banking authorities.

List of Europe’s top 20 banks by assets
Most of these lenders are among the “two dozen” large European commercial banks that meet the ECB’s preferred criteria of size and cross-border operational scope.

Without giving detailed guidance about preferred business models and market structures, Mrs. Lautenschlaeger has stated that “about two dozen large banks” in Europe (based mostly in the United Kingdom, France, Germany and Spain) meet the

SSM’s criteria of high-performing financial institutions. It follows that these institutions can expect to become (or remain) the big players on tomorrow’s European and global banking markets.

Market adjustment

As mentioned earlier before, the number of EU lending institutions fell from 8,525 in 2008 to 6,250 in 2017, according to figures compiled by the ECB. Year after year, Europe is losing hundreds of banks, either through failure or merger. Further shrinkage of the industry is expected in the coming decade.

In Germany alone, 40 to 60 banks disappear each year. According to a recent report, the German banking sector might shrink 90 percent by 2030; perhaps only 150 to 300 of 1,600 banks might survive. Other European countries will probably experience similar degrees of consolidation.

This evolution would certainly not be wholly due to ECB policies. Consolidation set in long before the EU banking union was launched. In the precrisis decade, domestic mergers were quite common in Europe, motivated mostly by economic reasons, such as cost savings or economies of scale. When the financial and economic crisis hit, merger activity dried up. Now growth is back on track, and banks are restructuring to improve their chances of survival. Balance sheets are being cleaned up, bad assets are being written down, workforces are being cut, traditional branches are being superseded by mobile technologies, and mergers are being weighed.

The whole banking sector is undergoing profound transformation. Traditional banks are increasingly under attack from new competitors. Financial technology startups, market infrastructure providers and global technology companies are turning the competitive environment for European banks upside-down. Customer expectations are changing, technology is disrupting business models, and harsh new regulatory requirements are undermining long-term strategies.

Big banks are already awake to the “fintech” revolution and have been swept up in a flurry of merger and acquisition activity with potential technology partners. Startups that once threatened to disrupt big financial institutions are increasingly willing to partner with them. Fintech companies are also consolidating to strengthen their market positions. This M&A craze is being driven by vigorous competition on a fast-changing market, as companies battle to build market share through organic growth or combinations with rivals.

Barriers to consolidation

Even so, the sector is apparently not slimming down fast enough to suit ECB supervisors. Mrs. Nouy has publicly stated her regret that M&A activity in the European banking industry in 2016 dropped to its lowest level since 2000.

Above all, she deplores that most mergers are domestic rather than cross-border in nature. The ECB has a clear preference for pan-European mergers, not least because cross-border entities fall under the SSM’s control, whereas domestic banks remain largely under the supervision of national authorities. The few big international transactions of recent years have mostly involved non-European investors from Asia or the Middle East. In 2018, for example, the 162-year-old Banque Internationale a Luxembourg was acquired by China’s Legend Holdings.

Headquarters of BIL in Luxembourg
One of the few significant banking acquisitions in Europe this year was the purchase of Banque Internationale a Luxembourg by China’s Legend Holdings (source: dpa)

Many obstacles obstruct the road to the desired cross-border mergers. Besides the high costs and risks involved in such transactions, there are a host of regulatory hurdles: differing national insolvency laws, complex and incompatible tax codes, inconsistent application of European rules. National regulators are still jealous of their own prerogatives, as EU supervisors discovered during the failed attempt by Sweden’s Nordea Bank AB to buy the Dutch lender ABN Amro in 2016.

The highest-profile cross-border idea recently is the proposed merger of Societe Generale and UniCredit. With 2.4 trillion euros in combined assets, the Franco-Italian group would belong to an exclusive group of the world’s largest banks. But depending on the final shape of the Basel III regulation (still not implemented after almost a decade), such gigantic and systemically risky entities may be subject to additional capital requirements.

That alone could be a stumbling block, since when calculating in trillions, an extra percentage point makes a big difference. Perhaps for this reason, there have been few signs of finalizing the transaction.

In the end, markets and not regulators generally have the last word on market structure and business models. This tends to undermine the entire “overbanking” argument.

Frustrated regulators

Perhaps the best description of EU banking supervision’s response to recent developments was given by Mrs. Lautenschlaeger in a June 2017 speech:

Are we satisfied with the business models of banks in the euro area? Are we satisfied with the progress banks have made by learning the lessons of the crisis? In all honesty, have you ever met a supervisor who was satisfied with anything? I haven’t – that is just not in our DNA.

A first question that comes to mind is whether a regulator’s proper role is to determine the shape of an industry or the business plans of individual banks. Ordinarily, these decisions should belong to market forces and company shareholders, respectively. For Mrs. Lautenschlaeger, however, the answer is clearly yes. “We need tough rules and tough supervisors who challenge banks’ business models,” she said.Even if one agrees, the next problem is how to correctly assess the market. For example, is Europe truly overbanked? That is a difficult judgment in a fast-moving, innovation-driven industry.

Third, certain corporate models – such as cooperative banking, for example – are not always well understood by regulators. Community banks specialize in small-business lending, which is a very different business from the cross-border megabanks promoted by the EU authorities. Yet these small lenders contributed greatly to economic growth. Since Europe’s economies are dominated by small and medium-sized businesses, the crucial role of local banks should not be underestimated.

Finally, the combined effect of regulatory changes and systemic transformation in the banking sector is not always understood by regulators. There might well be a threshold above which, to follow Mrs. Nouy’s reasoning, “too much” regulation can hurt rather than enhance market performance.

Perhaps the most striking thing revealed by the ECB’s recent discussion of overbanking is a general malaise among the current generation of banking supervisors. Eager to regulate away any symptoms as soon as they appear, policymakers have neglected their basic responsibility – to assist the financial sector with intelligently tailored regulations. This opinion piece was originally posted by GIS REPORT

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