Originally published in Financial News

Ever since the global financial crisis, European banks have been in a state of permafrost. The market value of all listed European banks today amounts to just 55% of those in the US — compared with 170% before the crisis.

At a time when Europe is adjusting to a new macroeconomic environment and scrambling to plan for the transition to a greener economy, the stalled progress in finalizing a banking union is a missed opportunity to foster the vibrant lending market that would fuel growth.

It is especially unfortunate that tensions between the European Central Bank and many of its regulated entities appear so high these days, as demonstrated in recent discussion around leveraged loans.

But with some thoughtful intervention, supervisors could make great progress in freeing European banks to lend more robustly now while we await the banking union.

There are, to be sure, certain structural reasons why US banks are so vastly outperforming European banks. The US has experienced faster economic growth and a faster recapitalization of its banks since the global financial crisis and enjoys deeper capital markets, higher interest rates and a more scaled banking sector.

But the regulatory and supervisory environment in Europe is another major contributor.

In a 27 January paper for the European Banking Federation, my colleagues and I showed that the regulatory and supervisory environment in Europe accounts for roughly one percentage point of the gap in return on equity between European and US banks.

That may not sound like much on its own, but it is a material difference.

Addressing this gap would provide European banks with capacity for as much as €4.5tn of additional lending, provided policies and measures are put in place to ensure that viable borrowers have growth opportunities. This would be an increase of almost 30% above current lending volumes. This is money the green transition effort desperately needs.

But European banks remain shackled in several ways.

First, the EU model to determine bank capital requirements is more complex and less transparent than the US version, and gives regulators wider discretion. Consequently, EU banks hold more capital on their books, not only to account for regulatory uncertainty but also their poorer ability to create more capital through retained earnings. In effect, European banks have buffers on buffers.

Second, EU banks are required to make contributions to deposit and resolution funds that are almost twice as high as those of US peers. Yet despite the higher cost, Europe still doesn’t have a single deposit insurance solution to meaningfully facilitate cross-border operations.

Third, in Europe the main driver of compliance costs in recent years has been the level of regulatory reforms. Member states have had wide flexibility to impose rules, increasing complexity for banks that operate across Europe. LexisNexis Risk Solutions estimate that anti-financial-crime compliance costs are twice as high in the EU as in the US.

This isn’t to suggest Europe’s supervisory regime is failing. The EU has achieved considerable progress with the establishment of the Single Supervisory Mechanism and the Single Resolution Mechanism. As a result of these substantial changes, the banking sector is much better capitalized today, less exposed to risks and more transparent.

The changes to the regulatory and supervisory framework have made banks in Europe more robust, as demonstrated by their resilience through the Covid crisis.

In an ideal world, Europe would build on this success and finalize the European banking union and the capital markets union. Absent that, here are three practical ideas to make tangible progress in the meantime.

First, supervisors should exercise thoughtful implementation of additional capital requirements. This includes the remaining Basel III agenda as well as the climate agenda, where regulators have an opportunity to use stress tests instead of imposing additional capital buffers.

Second, supervisors can streamline stress testing and other key supervisory processes.

Finally, supervisors can help to swiftly revive the EU securitization market, which represents about 1% of GDP, compared with about 18% in the US, by allowing for more risk-sensitive capital requirements for bank and insurance companies holding securitizations.

Together these moves would free up capital for banks to deploy to businesses that need financing. The economic opportunity is enormous: Unlike the US, where 77% of corporate funding is provided through capital markets, in Europe fully 70% of corporate funding is intermediated by banks.

Too much is at stake to continue down the current path. These three short-term objectives are not only helpful in the effort to revitalize the banking industry — they are also imminently achievable.

Read the original article on Financial News