A decade after the financial crisis, Europe’s banks just can’t seem to put their woes behind them, and that should worry more than a few highly paid executives.
While U.S. lenders saw their shares surge almost seven-fold since markets hit bottom in March 2009, their European rivals are trading barely above levels from a decade ago, and several have recently hit new lows. European banks are at the epicenter of almost 50,000 jobs that are being cut from the global industry as the prospect of lower interest rates for longer weighs on an already fragile industry.
For Europe’s economy, that’s a frightening prospect. Unlike the U.S. with its deep capital markets, companies on the continent are still highly dependent on bank lending. That’s one reason why, when credit markets froze in 2008, the effects reverberated longer in Europe than in the U.S., where companies could tap other sources of financing when banks pulled back.
European Union policy makers woke up to those problems after the crisis, embarking on the project for a “capital markets union” that would help reduce dependency on banks by slashing obstacles for market funding. While a slew of initiatives have been agreed to, more contentious issues such as differing tax regimes and insolvency frameworks haven’t been addressed. Adding urgency to those efforts is Brexit, which may leave the EU without its biggest and most sophisticated financial market come Halloween.
But there are still significant areas of concern for Europe’s ailing lenders.
Corporate Funding Sources
European banks provide the lion’s share of funding to the real economy. The many loans on their books need to be funded with costly capital. In the U.S., it’s much more common for companies to issue bonds which the banks then sell to investors such as insurers and mutual funds. This is one of the fundamental problems that EU regulators have been trying to solve since they saw bank credit dry up in the financial crisis.
Sources: Eurostat, Federal Reserve
Capital Markets Size
The lack of market-based financing in Europe is also evident in the size of national stock markets. The U.S. economy has a much larger pool of capital available that can be tapped by companies, while the EU’s stock markets as a whole are smaller relative to the economy and vary greatly between countries. Corporate bonds also play varying roles within the bloc, and are dwarfed by the U.S. market.
Sources: Bloomberg, BIS, World Bank
Household Assets
Compared to their U.S. counterparts, retail investors in the EU are a careful lot. Most of their assets are tied up in bank accounts that pay little to no interest, meaning they are benefiting little from the wealth creation in financial markets. Policy makers have been trying to channel more savings into stock markets, for example, through a new private pensions product. The European Capital Markets Institute called the outcome of political negotiations on the product a “messy compromise” that protects national interests.
Sources: Eurostat, U.S. Federal Reserve
Home Bias
One key aim of the capital markets union is to foster risk sharing across the euro area, so that an economic downturn doesn’t immediately spread to the banking sector. When European investors do venture beyond their savings accounts, they tend to prefer shares by companies in their home country, rather than seeking opportunities across Europe, underscoring how fragmented capital markets remain in the region.
Source: ECB
Fragmented Asset Managers
Asset managers, too, are dwarfed in size by their U.S. peers. Nine of the 10 biggest investment firms last year were based in the U.S., and just one in Europe. That has to do in part with different retirement systems, which generally have encouraged more private investment in the U.S. But the lack of a unified European capital market plays a role as well, forcing firms to deal with a multitude of regulations and distribution networks.
Source: Investment and Pensions Europe Research
Brexit Threat
London has the EU’s most active capital market, and the U.K.’s exit from the bloc will set back efforts to strengthen the region’s capital markets. Over the last three years, more equity was issued in London than on all other national stock markets. Britain’s capital also leads by many other metrics, such as trading activity or venture capital deals. The EU now faces the challenge of providing an alternative to companies that can compete with the London. No clear challenger has emerged so far, with U.K. firms moving to Frankfurt, Paris, Amsterdam and elsewhere in the euro area.
Source: Bloomberg
Bloated Balance Sheets
Because Europe’s companies depend more on loans than market funding, bank balance sheets are larger than in the U.S., where lenders have the added advantage that they can offload mortgages to Fannie Mae and Freddie Mac, government-sponsored enterprises that repackage and sell them to investors. The returns European lenders earn on those assets are dwarfed by their U.S. competitors.
Note: Data for 4Q 2018
Sources: EBA Risk Dashboard, FDIC Quarterly Bank Data
Bank Income
A more active and unified capital market would also help the EU’s beleaguered banking industry to diversify their income sources through fees from issuing bonds and equity for companies. Negative interest rates have put a strain on income from lending in the past years, and with the economy weakening again, that’s not likely to change any time soon.
Source: FDIC, EBA
None of these issues will be sorted out quickly. Even if politicians agree on the goal of weaning companies off bank financing, some reforms will require difficult political decisions. There's no shortage of ideas on how Europe's quest for more efficient capital markets can be taken forward. When the new EU executive arm takes over in November, it will have its work cut out.