The profitability of the French banking sector is insufficient and remains lower than lenders' cost of equity, but it should start improving by the end of next year, according to the country's central bank.

Return on equity — a key measure of profitability — for the six largest French lenders, including BNP Paribas SA, Société Générale SA and Crédit Agricole SA, stood at 6.3% at the end of 2017, down from 6.5% the previous year, the central bank said. This compares to a European average of 6.4% in 2017.

Bank profits across Europe have come under pressure from an extended period of low interest rates. But those in France remain slightly lower than average, because French banks have continued to grow their balance sheets at a time when peers elsewhere in Europe have scaled back their activities, Ivan Odonnat, deputy director for financial stability and operations at the Bank of France, told a news conference in Paris on June 25.

But the central bank noted that analysts are expecting French banks' ROEs to improve by the end of 2019, albeit at a slower rate than those of other large European lenders.

Odonnat said French banks' cost of equity, or the return that investors require for the risk they undertake, was lower than 9% on average, below investors' expectations. But he said that while French lenders have increased their balance sheets, they have also doubled their capital levels over the last 10 years, giving them an adequate backstop for their larger size.

A sharp interest rate rise could have a negative impact, as the heavily indebted French private sector could face difficulties in paying back loans. Odonnat said nonfinancial companies could see their interest rate charges rise dramatically and noted that a surge in lending has included loans to small to medium-sized businesses, increasing potential risk.

Concerned by the level of private sector debt and bank lending, French authorities have taken measures to cool the financial system. They will impose a countercyclical buffer of 0.25% on banks' risk-weighted assets, and from July 1, 2018, lenders will have to limit their exposure to highly indebted large firms based in France to 5% of their capital.

The central bank also said a pursuit of profits in a low-interest-rate environment could encourage some banks to take more risk, especially in the leveraged buyout market.

Odonnat said the central bank was closely watching the fast-growing LBO market, saying banks were loosening their lending conditions and nonbanking institutions were also developing LBO activities as they sought higher returns. However, the report noted that LBO exposure remains low in France at €35 billion, compared to €1.6 trillion in total loans to companies.