27 September 2016

Financial Times: Europe’s banks need consolidation to find stability

Stability and integration of the European financial system are two sides of the same coin. A well-designed regulatory framework needs to set a proper balance between the two complementary objectives, argues Lorenzo Bini Smaghi.

European central bankers and supervisors have recently called for greater consolidation of the banking system, in particular in the eurozone, and for accelerating the capital market unionproject proposed by the European Commission.

These are welcome recommendations. The excessive fragmentation of the European banking system, especially in some countries, is hurting its profitability. [...]

However, fulfilling such wishes might be more complicated than expected. Bank mergers are certainly welcome when they create value for shareholders. But a number of obstacles currently make such mergers and acquisitions particularly difficult in Europe, especially across borders. The main obstacle is regulation. As banks become larger through consolidation they become subject to increasingly tight regulatory hurdles, in particular with respect to capital and liquidity requirements. Bigger banks are negatively affected by capital surcharges, aimed at reducing the risk of being too big to fail and at compensating for what is perceived as a greater operational risk. On the other hand, those operating in several eurozone countries are still not able to allocate their liquidity and capital within the group as they wish, and remain subject to some restrictions imposed by local authorities.

The differences in national legislations and the absence of an integrated European capital market reduce the scope for synergies in costs and revenues that can be extracted from consolidation. In the current environment, short- and long-term funding costs for banks may rise in line with their size, because of factors including concentration risks. [...]

The main objective of the Single Supervisory Mechanism is to “increase financial integration and stability” in the eurozone. While substantial progress has been made in improving stability, less has been done in terms of integration. If anything, eurozone banks are downsizing their activities, especially in the capital markets, and refocusing mainly towards their domestic clients. That is exactly the opposite of what is happening for US banks.

Such a development represents a threat for the realisation of the capital market union. Aside from the need to harmonise national legislations, including on bankruptcy, the development of a market requires first and foremost the involvement of major players that are active in helping companies issue stocks and bonds, in selling such assets to investment funds and in trading which each other to ensure the necessary market liquidity.

[...] It would be an illusion to think that the capital market would develop without the emergence of major banking players on the continent. But such a support cannot be deployed if regulation continues to penalise banks’ size or discourage their activity in the capital markets (or even prohibit it as foreseen by some proposals pending in the European Parliament).

Stability and integration of the European financial system are two sides of the same coin. Unless the system becomes more integrated, its profitability is bound to remain weak and unable to provide sufficient funding to support the economy, either directly or through the market. A fragmented system is fragile and, in the end, not able to ensure stability. A well-designed regulatory framework needs to set a proper balance between the two complementary objectives.

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