The European banking sector is currently not earning its cost of capital. Their US counterparts have seen theirs return to pre-Corona levels.

European banks are as robust as they have rarely been in the past decade. Their stability is thanks to measures taken since the global financial crisis to strengthen the regulatory framework for banks in the European Union (EU). Credit institutions are now required to hold more and better quality capital and larger liquidity buffers to withstand added stress to the banking system.

A sophisticated safety net has been put in place for larger banks that cannot be wound down without threatening financial stability. Thanks to such measures, European financial institutions survived the COVID-19 pandemic relatively unscathed while supporting the economy.

 Falling Behind

Despite its strength, the EU banking sector is failing to earn its cost of capital, while its US peers have returned to pre-crisis profitability levels, a study commissioned by the European Banking Federation and conducted by management consultants Oliver Wyman, concluded.

The study points to several reasons: Comparatively weak growth in the euro area, late political reactions to the European debt crisis, and strong fragmentation or lack of scale against the backdrop of rising minimum operating costs. Moreover, negative interest rates, in turn, weighed on banks' earnings at a time when they needed to strengthen their capital buffers.

Structural Weaknesses

Structural barriers in the eurozone prevent banks from exploiting synergies between markets, leaving the banking union incomplete for the foreseeable future, according to the study. The integration of capital markets in the EU is still in its infancy, the study's authors said. The European securitization market accounts for about 1 percent of GDP, compared with about 18 percent in the United States.

European and US banks operate not only with different business models but in different regulatory environments. The additional difference in regulatory costs for EU banks compared to their US counterparts explains the 0.8 to 1.0 percentage point difference in return on equity (RoE), according to the study.

Gap Could Widen

The gap could widen further. Oliver Wyman explains this in part through the upcoming requirements planned by the European Central Bank (ECB) to cover the impact of climate risks on capital. The European Banking Authority estimates the completion of Basel III will increase minimum Tier 1 capital requirements by an average of 15 percent from current levels in the EU banking sector.

The EU approach to setting capital requirements is more complex, leaves more discretion to regulators, and can be perceived as less transparent, according to the study. The resulting uncertainty is one of the reasons why banks in the EU tend to hold excess capital on average, it says.

UnleashingNew Forces

A review of current capital requirements and supervisory processes could create a capacity for 4- to-4.5 trillion euros in additional bank lending, a hypothetical scenario showed. That's assuming policies and measures are put in place to ensure profitable borrowers have growth opportunities that support additional loan demand.