Thoughts on macro conditions for European banks for XETR:CXPB by actaeon_equity

It is no secret that in the Basel III era, the core profitability of European banks has not been satisfactory. While European banks’ return on equity is not even close to the pre-07 levels and falls short on their cost of capital, US banks enjoy double-digit ROE and significantly higher valuations. This mismatch made me wonder whether the current macroeconomic landscape gives EU banking some hope for a rebound and closing the US-EU profitability gap.

At the first sight, forward-looking macro indicators seem to be favourable for EU banks. GDP growth rapidly accelerated after the 2020 slump, inflation is remarkably high and the central bank will have to increase interest rates sooner than later. But still, return on equity and consequently, valuations of European banks still look quite modest when compared to their US equivalents. The underlying problem behind the profitability underperformance of European banks is overcapacity. Competitive pressure is high and additionally, banks have to deal with the increasing fintech sector. The problem could be targeted by the supervisors (higher capital requirements for new entrants, lack of “credible integration plans” etc) but market forces are necessary to successfully combat low concentration.

Historically, the years following implementation of more strict regulation (Basel III) should result in decreased profitability of banks (no surprise) and consequently more movement towards higher market concentration. However, last year M&A volume in European banking was far from impressive. According to the KPMG European Banking Consolidation report, the volume of mergers and acquisitions involving European banks in 2020 reached its lowest level since the 07-08 crisis. To be clear, a strong downtrend in the M&A volume has been observed since 2010 so the COVID-19 outbreak in 2020 was not a direct cause. The current financial landscape seems to be favourable for mergers and acquisitions volume increase. Low interest rates, relatively cheap bank equity, loosening of M&A regulation and need for restructuring in response to digital transformation. Thus, forecasts for the M&A volume in banking are relatively generous.

The exogenous determinants I described are only a fraction of the whole banking landscape. Bank-specific factors and digital transformation are equally valid components. Nevertheless, bearing in mind the historical tendency of banks to concentrate more in response to new regulations and promising M&A volume outlook, I am optimistic.

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