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EU banks to lag U.S. peers if market fragmentation persists, says Moody's

EU banks struggle to keep up with their U.S. peers because their profitability is constrained by more than weak fundamentals, according to a Moody's report.

The fragmentation of EU markets adds an additional structural challenge for European banks, Olivier Panis, senior credit officer, said during a presentation of the report at the Moody's London Banking conference Oct. 3.

This is in addition to cyclical factors, low interest rates and weaker economic growth, according to Panis.

Higher costs

Fragmentation is a key factor driving the increase in cost-to-income ratios of European banks while ratios are on the decline in the rest of the world, he said.

Between 2011 and 2018, cost-to-income ratios at the 20 largest U.S. banks dropped 9 percentage points while they grew by 3 percentage points at the 20 largest European banks over the period, Panis said.

The fragmented European banking environment is a considerable hindrance to cost-efficiency, according to Moody's. Germany and Austria, where the largest five banks accounted for just 29% and 36% of domestic sector assets in 2018, show some of the highest average cost-to-income ratios with 75% and 65%, respectively.

But in countries with more consolidated banking systems, such as the Nordics, the Netherlands and Czech Republic, average cost-to-income ratios are notably lower, ranging from 40% to 60%.

The cost pressure is especially worrying as at this point in the cycle it will be hard for European banks to increase lending in order to offset lower margins, Panis said. To increase the number of loans will be challenging in a slowing economy with the implementation of higher countercyclical buffers, he said.

In the past few years, European banks have also relied on the reduction of loan-loss provisions to increase profits. In the future, that trend will not continue in the vast majority of EU countries, Panis said.

"We reached the bottom of cost of risk in the middle of 2018. It will be difficult to go lower than that," he said, adding that the cost of risk has already started to gradually increase.

No integration

Market fragmentation both on an EU and national level also prevents banks from using diversification as a tool to increase profitability, according to Panis. Diversification depends on the size and scope of the banks' activities and the size of their own market, he said.

Since the financial crisis, consolidation in European banking has largely stalled while in the U.S. the number of banks has declined significantly, Moody's data shows. The largest EU banks hold 60% of total banking assets in the bloc, compared to some 80% held by the largest 20 credit institutions in the U.S., the rating agency said.

At the end of 2018, 83.5% of EU banks' lending stock was domestic with only 8.3% going to counterparties in other EU countries. Since the Riegle-Neal Interstate Banking and Branching Efficiency Act — which removed some inter-state banking restrictions in the U.S. — the number of American banks has more than halved to 5,000 in 2018, from 10,450 1994, Moody's said.

"Segregation into separate domestic banking markets constrains the efficiency of EU banks compared with U.S. banks, erodes their profitability and weakens their capacity to invest in their digital transformation," Moody's said.

As greater integration of banking activities in Europe will be challenging to achieve in the foreseeable future, EU banks are expected to continue to underperform U.S. peers. While there will be some in-market consolidation in the various EU countries, no large cross-border bank mergers are expected in the near term, Panis said.

The completion of the European banking union project, aimed at harmonizing banking regulation and supervision across the EU, is essential for banks to increase profits. This will ease cross-border access, drive consolidation and improve the allocation of liquidity and capital, which would help EU banks to compete with global rivals, Moody's said.