FS in Focus #5 - Banking Consolidation: A Strategic Imperative? and why the hype ?

co-authored with Christian Edelmann - co-Managing Partner of Oliver Wyman Europe

In recent times, banking consolidation and scale has emerged as a critical agenda item in Europe. This strategic imperative was highlighted by President Macron prior to the EU legislative election and, Enrico Letta, whilst not mentioning Banks specifically in his latest report, insisted that scale matters for Europe to play Big!

In this edition of FS in Focus, we delve into the reasons behind this need and the requirements for its realization.

The Fragmented European Banking Landscape – a bit more color

The European banking landscape has undergone significant transformation since the Global Financial Crisis (GFC). However, it remains fragmented, with a low level of profitability. While the market has consolidated domestically post-GFC, it still lags behind the United States in terms of consolidation. For instance, to achieve a similar level of consolidation as the top five banks in the US, Europe would require 30+ banks 1. The biggest US bank has an operating income approximately three times higher than the biggest EU bank

De-risking and Capital Levels

Driven by regulatory measures, the sector has successfully de-risked and now holds record levels of capital. Banks have shifted their balance sheets towards less risky and more liquid assets, resulting in a Common Equity Tier 1 (CET1) ratio that has increased from 6% in 2011 to nearly 16% in 2023. However, despite these efforts, the overall profitability of the sector remains low, with a return on equity (ROE) of 7.6% compared to the industry's expectation of 10% or higher. Moreover given the average price to book ratio of EU banks over the past decade around, implying a cost of equity at 15%+, EU banks have struggled to earn their cost of equity.

Profitability Challenges and Price to Book Ratio

This lack of profitability is reflected in the low levels of Price to Book ratio relative to the US market. Over the past decade, the Price to Book ratio in Europe has declined from 1.4x book to 0.6x book, erasing a staggering $1.3 trillion in shareholder value.

Heterogeneity in the European Banking Landscape

A closer examination of the European banking landscape reveals a lack of homogeneity. Various business models coexist, each with different profitability drivers. These include cooperative banks, state-owned banks, listed banks, and regional banks. From a country perspective, the profitability of banks is influenced by factors such as concentration, absence of skewed pricing given differing profitability drivers, and growth. The Czech Republic emerges as the most profitable banking market in Europe, while profitability in the German market remains a challenge due to the competitive nature of this market.

Product and Business Line Perspectives

From a product and business line perspective, retail markets in Europe remain largely domestic, with specific regulations governing loans and deposits. In contrast, wholesale markets are increasingly global, with a critical need for scale. US players have gained a 12%-points market share, now holding close to 50%, over the past decade, making it challenging for European banks to compete. However, there have been some moves towards less locally specific product lines such as leasing, consumer finance, and payments.

What does it mean for Europe and the European Economy ? A diminishing Role of Banks in Financing the European Economy, a broken financing continuum and a more expensive financing options?

The diminishing role of banks as financiers of the European economy is a cause for concern. Non-Bank Financial Institutions (NBFI) are playing an increasingly prominent role in financing, with risky and profitable assets being transferred to NBFI. This shift has been accompanied by a lack of a functioning Capital Markets Union (CMU), resulting in a broken financing continuum in Europe.

Bank financing remains relatively cheap for less risky companies, while private credit financing is significantly more expensive for others. This disparity hinders the growth of EU corporates, particularly midcaps, who are unable to access capital markets directly for debt issuance.?

Also, the lack of a more pan-European banking market with larger banks poses three major risks for Europe. Firstly, it reduces resilience to economic shocks as ring-fencing practices restrict capital flows and liquidity across borders, limiting banks' ability to diversify risks and funding. Secondly, it impairs financial stability by creating pockets of vulnerability and potential contagion effects if these vulnerabilities materialize, with limited coordination among national authorities hindering resolution and exacerbating systemic risks. Lastly, it diminishes financial strategic autonomy as European banks struggle to compete with non-European firms, particularly in global businesses like capital markets, and have a tendency to focus on their home markets during crises, increasing dependence on them.

What does it mean for European Banks? A stuck value creation story and disgruntled investors

European banks face several challenges in this evolving landscape. They are participating in revenue pools that are structurally less profitable, with limited growth prospects. The constrained balance sheets of banks, coupled with the absence of a CMU, restrict their ability to tap into new revenue pools available to US banks. Cross-border growth and efficiency options for European banks are also limited. Disincentives to merge cross-border, such as Global Systemically Important Bank (GSIB) buffer thresholds and trapped liquidity and capital, pose significant barriers. Additionally, local specificities hinder the realization of cross-border efficiency synergies.

Given these challenges, domestic consolidation or cost-cutting measures are the primary options for European banks to boost profits and create value. Some banks have already embarked on domestic consolidation initiatives, while others opt for share buybacks and dividends to enhance share prices, which is the preferred option for investors.

The Imperative for Pan-European Consolidation and creation of Truly “European Banks”

Europe faces significant financing challenges linked to war, energy, digital and Climate transition at a time when government budgets are highly constrained.? EU banks must play a pivotal role in allocating savings to the right projects seamlessly across the continent. Sovereignty and financial stability are also key considerations, as EU banks need to compete globally and create stronger and more profitable institutions.

To foster the creation of truly European banks, several technical issues need to be addressed. Firstly, the development of a uniform European Deposit Insurance Scheme (EDIS) has been stalled due to concerns about varying risk levels across EU members, hindering the integration of balance sheets. Secondly, a common backstop approach is necessary, as the current Single Resolution Mechanism (SRM) lacks an operational backstop fund to supplement the Single Resolution Fund in the event of simultaneous resolution of multiple large institutions. Cross-border liquidity transfers within banking groups and the complex EU approach to requirements and buffers also pose challenges. Additionally, variations in national regulations and accounting treatment need to be addressed to create a more favorable environment for cross-border mergers and acquisitions.

?Alongside these technical issues, a fundamental change in mindset and regulatory approach is needed, with a strategic will to create truly "European Banks" and the implementation of appropriate incentives, finding the right balance between Financial Stability (main focus to date) from one side and growth and competitiveness of the sector from the other. This may include lower capital requirements for cross-border mergers, defining a European perimeter for banks, and establishing a European-exclusive backstop.

?While these changes may face resistance due to national customs and culture, bold and radical "top-down" action is necessary for Europe to succeed in an increasingly polarized world.

1 This includes savings banks as separate institutions?