This article was initially published in the Eurofi magazine.
Europe faces an array of economic challenges, from the energy and digital transitions to remilitarization. Governments are increasingly constrained by fiscal limits, so private sector financing will be crucial to these efforts.
That would be much more straightforward in the United States, where capital markets cover roughly 70% of all corporate financing needs. But in Europe, the figure is just 30%.
The role of banks in European financing
A true Capital Markets Union across Europe would help greatly, but it won’t happen overnight. Private credit remains materially less developed than in the United States, and has historically focused more on providing debt financing for buyouts.
That leaves banks. Unfortunately, European banks aren’t sized for the task. While their balance sheets have been stable over the past decade, tougher capital requirements have drastically reduced their risk appetite. The balance sheets of the top five US banks are 2.8 times larger than those of their European peers, allowing for more diversification, larger exposures, and greater investment budgets with which to jump to the forefront of technological developments.
Risks of limited pan-European banking
Moreover, despite the ever-larger need for pan-European financing, European banks still operate largely within national borders. The top five banks in Europe by assets account for just 34% of the overall market, compared with 75% in the United States.
Europe’s failure to foster large banks operating across a pan-European market creates risks. The first: reduced resilience to economic shocks. By restricting capital flows and liquidity across borders, ring fencing practices limit banks’ ability to diversify risks and funding.
The second: impaired financial stability. By protecting the borders of national banking systems, ring fencing can create pockets of vulnerability. In crises, insufficient coordination among national authorities can hinder resolution and exacerbate systemic risk.
The third risk: diminished financial strategic autonomy. By operating mainly within national borders, European banks struggle to compete with large non-European firms, particularly in global businesses such as capital markets. History has also shown that during times of crisis these global firms retrench to their home markets.
Technical challenges and solutions for European banks
Many challenges are deeply ingrained in national customs and will be difficult to change overnight. But five are technical in nature and can and should be addressed urgently:
1. The European Deposit Insurance Scheme
Ongoing proposals to develop a uniform EDIS have been stalled due to concerns of dissimilar risk levels across EU members, hampering integration of balance sheets. A reinsurance-based solution might revive talks.
2. Common backstop approach
Work toward this goal must continue. A single resolution mechanism is not yet equipped with an operational backstop fund to supplement the existing Single Resolution Fund in case of contemporaneous resolution of multiple large institutions.
3. Cross-border liquidity
The GSIB scoring methodology (which includes surcharges depending on the home country) keeps capital ratios higher for cross-border mergers than domestic ones. Impediments also remain to cross-border liquidity transfers within banking groups.
4. National regulation
The EU regulatory framework allows for variations in domestic regulation of tax, mortgages, customer protection, insolvency, and other areas. For the next EU Commission there might be a few quick wins achievable, such as in corporate or dividend taxation.
5. Accounting hurdles
Unfavourable accounting treatment (such as the implications of recognition of fair value adjustments of loans and bonds portfolios) makes mergers and acquisitions less appealing.
Prioritizing growth and competitiveness in banking
In addition to these technical fixes, a more fundamental change in mindset is required. Authorities and regulators need to shift from prioritizing stability at all costs to also considering growth and competitiveness. We need the strategic will to create truly European banks, accompanied by proper incentives. What if, for example, capital implications were lower for cross-border mergers than for domestic? Imagine if banks operating on a to-be-defined European perimeter (such as providing financing to corporates and sovereigns in more than x markets, with a certain minimum volume level to ensure relevance) could receive capital relief commensurate with their more diversified business model. Likewise, what if a separate backstop for these European banks were created?
Granted, larger banks come with their own risks. Despite the regulatory overhauls since the global financial crisis, none of the victims of last year’s banking crises has gone through the resolution process foreseen by the Basel regulations. Hence, this framework remains to be tested in a real case. Nevertheless, if Europe wants to succeed in an increasingly polarized world, radical “top down” action is required.
Read the original piece here.