10. CONSOLIDATION OF THE EUROPEAN BANKING INDUSTRY: OBSTACLES AND POLICIES Martin Boer and Andrés Portilla, Institute of International Finance (IIF)1 10.1. ABSTRACT Consolidation of the European banking industry can lead to stronger and more resil- ient banks, and can also boost profitability due to greater economies of scale. However, while the business case for consolidation is clear, there are a number of significant ob- stacles preventing mergers and acquisitions. The obstacles arise from various economic, political, regulatory and cultural factors, or are related to the business environment in which European banks currently operate. Global and regional geopolitical uncertainty and rapid and profound changes in the global banking industry’s outlook due to innova- tion and technological change add to these challenges. This chapter reviews the current European banking landscape, considers the various obstacles to consolidation and dis- cusses policy recommendations aimed at strengthening the European banking system to achieve a healthier, more stable and more profitable future. Keywords: Bank consolidation; EU Banking Union; EDIS; Banking regulation; Cross-border banking. 1 Martin Boer is Director (Regulatory Affairs) and Andrés Portilla is Managing Director (Reg- ulatory Affairs) at the Institute of International Finance (IIF) in Washington, D.C. The views ex- pressed in this article are those exclusively of the authors and do not necessarily represent the views of the IIF. With thanks for the invaluable research assistance to Kristina Haberson of the Vienna University of Economics and Business. 263 THE EURO IN 2020 10.2. INTRODUCTION Today’s global banking industry is radically different than it was before the global financial crisis. Globally, banks have fundamentally transformed their balance sheets, in- creasing both the quantity and quality of their capital, their funding strategies and overall liquidity. European banks, in line with the global trend, have substantially strengthened their capital positions and liquidity. However, a number of factors have negatively impact- ed their profitability, with many banks currently unable to meet their cost of capital. Tra- ditional corporate finance concepts indicate that mergers and acquisitions (M&A) can create greater economies of scale, leading to higher profitability. A consolidated bank- ing system would become healthier, more stable and more profitable. A healthier finan- cial system would also have a positive impact on the broader European economy, which would help spur investment, employment, trade and economic growth. That, in turn, helps create a positive loop where the banking sector would benefit from the strength of the broader economy, as it did over the past decades before the financial crisis. If such a premise is true, a necessary question is to identify why greater consolidation is not taking place and what policymakers and authorities can do to stimulate greater consolidation? These are all important questions that we will explore in this chapter. 10.3. IS EUROPE OVERBANKED? Danièle Nouy, the former Chair of the Supervisory Board of the European Central Bank (ECB) delivered a spirited speech in Madrid in 2017 entitled, “Too much of a good thing? The need for consolidation in the European banking sector.”2 Ms. Nouy argued that banking in itself is a good thing, but when the banking sector grows too large, an economy can become overbanked and this can seriously harm both the health of the banks themselves, and by extension, that of the wider economy. Overbanking may occur if there are too many banks that for various reasons do not exit the market. This can lead to high competition between the banks and subsequently to low profits, poor or no dividends and a reduced capacity of these institutions to build up capital buffers. Furthermore, banks would be inclined to take on higher risks to increase their profits, which could cause instability. The banking sector could be too large not only in comparison to other sectors, which may lead to inhibited growth, but also in compar- ison to other sources of funding, such as capital markets, which might cause bank-based economies to be more strongly hit by a crisis. Moreover, the banking sector could be too large with regards to its assets, which may be a sign that the economy is over-indebted. Therefore, an economy could be overbanked in many, interconnected, ways.3 More recently, Andrea Enria, the new Chair of the ECB Supervisory Board, said 2 Danièle Nouy 2017. “Too much of a good thing? The need for consolidation in the European banking sector.” September 27, 2017 3 Danièle Nouy 2017. 264 CONSOLIDATION OF THE EUROPEAN BANKING INDUSTRY: OBSTACLES AND POLICIES that removing excess capacity in the system continues to be a structural challenge for the European banking sector: “Consolidation would be beneficial for the sector, but there seem to be a number of impediments blocking progress.”4 Over the last decade, European Union (EU) officials have tried to prioritize consolidation of the European banking industry, especially once the financial crisis had exposed weaknesses across the financial sector, that were further exacerbated by the links between the banking and the sovereign sectors. As the financial crisis spread across the euro area it was clear that a deeper integra- tion of member states’ banking sectors was needed and had not been achieved through earlier attempts at approximating bank regulations across EU jurisdictions, especially as the financial systems across these countries were deemed to be strongly interdependent. The European Banking Union was created in 2014 to stimulate this integration through the establishment of a Single Supervisory Mechanism (SSM) and a Single Resolution Mechanism (SRM), in addition to a Single Rulebook. While these institutions have already achieved a great deal in terms of making super- vision more consistent and providing a common resolution framework, Banking Union remains unfinished and European banks - especially retail banks - still mostly operate on a national basis. A fully integrated single market for financial services remains a long way off. 10.4. BANKING IN EUROPE TODAY The euro area banking market has by and large remained fragmented since the be- ginnings of the financial crisis. Evidence of this, firstly, is that intra euro-area cross border claims, and the market share of foreign branches and subsidiaries have declined since 2008; and, secondly, that in 2017 domestic institutions made up 86% of loans to euro-area non-fi- nancial institutions, a number which has not changed over the last few years. In addition, in 2016, foreign-owned banks’ share of the domestic banking system was only 17%.5 It is difficult to determine what the optimal size of a financial system should be. There are strong benefits to consolidation but too few banks could also lead to lack of com- petition which may harm consumers, lead to less innovation and weigh on economic growth. In 2018, there were 6,088 credit institutions in the 28 member countries of the Eu- ropean Union, down 2.6% from the previous year, and a reduction of 2,437 (29%) since 2009, meaning that about one in four has disappeared since the financial crisis.6 4 Andrea Enria 2019. “The banking union – a personal view on its past, present and future.” October 30, 2019. 5 Philipp Hildebrand 2018. “What next for banking union?” June 8, 2018. 6 European Banking Federation 2019. “Banking in Europe: EBF Facts & Figures 2019” 265 THE EURO IN 2020 This decline is comparable to the United States, where there were 4,715 commercial banks in 2018, down 31% from 6,829 in 2009.7 FIGURE 1: EUROPEAN BANK M&A HAS DWINDLED BY VALUE ($BLN) Figure 1: European bank M&A has dwindled by value ($bln) Sources: Deutsche Bank, Dealogic But it is also the case that the consolidation that has occurred in Europe over the past few years has mainly occurred domestically, within the borders of Member States. Figure 1 shows that total European bank M&A has dwindled to less than $10 billion in 2018, from around $130 billion in 2007. The number of cross-border mergers and acquisitions has also fallen over the recent years with only 28 deals in 2017, compared with 65 in 2010. 8 Bank mergers, especially cross-border, seem to have slowed down since the financial crisis, not only in value, but also in the number of transactions.9 Another way to determine the relative size of the European banking sector is the ratio of bank assets to GDP, which stands at 86% in the EU, ranging from Denmark (179%), Portugal (135%) and the Netherlands (127%) at the higher end, down to Ro- mania (40%) and Cyprus (18%) at the lower end. In comparison, total assets of the U.S. banking sector accounts for only 63% of GDP.10 There are well-known reasons for this, including distinct banking system structures, mortgage markets and the respective devel- opments of capital markets, but the difference remains stark.11 7 FDIC Statistics at a Glance 2019. “Historical Trends, as of June 30, 2019.” 8 ZEB 2018. “European Banking study” November 2018. 9 Deutsche Bank 2019. “How to fix European banking…and why it matters.” March 13, 2019. 10 Global Economy.Com 2019. "Bank assets to GDP in the European union and United States" with 2016 data being the most recent. 11 Danièle Nouy 2017. 266 CONSOLIDATION OF THE EUROPEAN BANKING INDUSTRY: OBSTACLES AND POLICIES Furthermore, the five largest banks in the U.S. share 50% of bank assets, whereby the five largest EU banks share less than one-quarter of the assets of all banks in the bloc. Therefore, the U.S. banking sector is more than twice as concentrated as the European market. The U.S. banking sector represents a single market, while Europe is fragment- ed into national markets.