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Too much of a good thing? The need for consolidation in the European banking sector

Speech by Danièle Nouy, Chair of the Supervisory Board of the ECB, at the VIII Financial Forum, Madrid, 27 September 2017

There is something that most of us have learnt one way or the other: you can have too much of a good thing. Take chocolate, for example. It is a good thing in moderation, but too much of it can literally be nauseating, as many children have discovered. But there are also less obvious examples. A recent study found that too much vitamin B can cause serious health problems in the long term.[1]

And the same is true for the economy’s vitamin B – banking. In principle, banking is a good thing. But when the banking sector grows too large, an economy can become overbanked. And this too can seriously harm the health not just of the banks but of the entire economy.

So let’s take a closer look at this issue. There are three questions we need to answer. First, what harm can an oversized banking sector do? Second, how does this relate to Europe, which is often said to be overbanked? And third, what can be done to downsize a banking sector that has grown too large?

Has the European banking sector become too much of a good thing?

To begin with, the concept of overbanking is not at all clear and can mean many things. Each of these things, in turn, causes different health problems. Let me give you a few examples.

First, overbanking may occur if there are too many banks. Or rather, if there are too many weak banks, which for one reason or another do not exit the market. Banks will then compete fiercely with each other. Profits will be low, and banks will have less capacity to build up capital buffers. At the same time, they will be inclined to take on too much risk to shore up their profits. And this might well impair stability.[2]

Second, the banking sector can be too large when compared with other sectors of the economy. In that case, it might tempt away too many talented people from other sectors. Just think of all the engineers and physicists who turned to building financial instruments when they could have been solving real-world problems.[3] This might harm growth.

Third, the banking sector can be too large when compared with other sources of funding, such as capital markets. And that can cut two ways. Over a normal business cycle, bank-based economies perform slightly better. But this changes when a crisis erupts. Then, they suffer more and take longer to recover.[4]

Fourth, the banking sector can be too large in terms of assets, which would imply that the economy is over-indebted. Take credit to private households, for example. There are studies which suggest that credit can indeed become too much of a good thing. They find that, once private credit exceeds GDP, it becomes a drag on economic growth.[5]

These examples show that an economy can be overbanked in many ways. And all of them are interconnected. This makes overbanking quite a complex concept to analyse.

The other problem is that there is no clear threshold. When does an economy become overbanked? When does “much” become “too much”? As the European Systemic Risk Board states: “The difficulty of the question lies in the words “too much”, which require a normative answer”.[6]

So what is the answer with regard to Europe? It is true that, over the past few decades, the European banking sector has indeed grown quite a lot – maybe even too much. This came to a halt after the financial crisis broke out. Since then, the banking sector has indeed shrunk.

Let’s take a look at a few figures. Since 2008, the number of banks in the euro area has declined by about 20%, to around 5,000. And the number of bank employees has fallen by about 300,000, to 1.9 million. Total assets of the euro area banking sector peaked in 2012 at about 340% of GDP. Since then, they have fallen back to about 280% of GDP.

So, the European banking sector has become a bit smaller, but it is still quite large by international standards. The banking sector in the United States, for instance, is much smaller. Total assets of the US banking sector account for just 88% of GDP. This, of course, also reflects the fact that capital markets play a much bigger role in financing the US economy.

All in all, it seems that the European banking sector might indeed have become too much of a good thing. And we can see at least one of the health issues related to this – many banks in the euro area do not earn their cost of capital. It seems that there are too many banks competing for customers.

So what can be done?

Shrinking the banking sector: the role of bank failures

Let us first look at individual banks. Given the difficult circumstances and fierce competition, they need to act. They need to review their business models. They need to find ways to prosper even when interest rates are low. They need to deal with digitalisation, stronger rules and tougher supervision. And they need to clean up the legacy assets on their balance sheets.

By doing all this, banks might very well become smaller due to deleveraging, for example. Having smaller banks could be one step towards a leaner banking sector. And as I mentioned, the total value of assets held by European banks has indeed fallen since the crisis.

But that’s not all there is to it. The hard truth is this: competition means that not everyone can win. So we would expect that some banks will have to exit the market. And that leads us to a crucial question: how can a well-functioning market economy become overbanked in the first place? How can there be so many banks that they do not earn their cost of capital?

Clearly, something isn’t working properly. Finding out what that is and fixing it will help the banking sector to shrink. In very broad terms, there are two ways in which banks can exit a market. Either they fail and cease to exist or they merge with other banks.

Now, failure has always been a thorny issue for banks. The financial crisis taught us that a failing bank might drag the entire financial system into the abyss.

One reason for this is that banks are so closely intertwined. If one of them catches a cold it quickly passes on the virus. Another reason is that confidence plays such a big role in finance. And confidence can quickly be lost. Once that happens, even healthy banks can get into trouble. Funding dries up and they are suddenly struggling to survive.

With that in mind, policymakers did two things during the crisis. First, they provided ample liquidity. The aim was to shield healthy banks from the loss in confidence that had gripped the sector. And it certainly did help to contain the crisis. However, it might also have delayed necessary restructuring.

Second, many governments propped up failing banks with taxpayers’ money. Their concern was to avoid a breakdown of the entire financial system. However, this cost-free public insurance created all the wrong incentives for banks, and it prevented weak banks from exiting the market.

Against that backdrop, we can draw only one conclusion: banks must be allowed to fail. This is probably the most important thing that can be done to make the market work again. Not only would it increase market pressure by correcting the incentives for banks and investors, it would also help the banking sector to shrink.

The good news is that Europe now has a Single Resolution Mechanism, the SRM for short. The SRM ensures that banks can fail without breaking the financial system. Earlier this year, the SRM passed its first test when three large banks failed. These cases were handled efficiently and effectively.

To sum up: an important feature of the market has been restored. Unprofitable banks can now exit the market in an orderly fashion. This will help the banking sector to shrink in at least two ways. First, it will put further pressure on banks to adapt to current challenges; and second, it will enable market forces to tackle the problem of unprofitable banks.

What is the role of mergers and acquisitions?

Shrinking the banking sector is not just about bank failures, of course. Bank mergers could also play a role in helping to reduce excess capacity and make banks more efficient.

And I am not just talking about domestic mergers. The European banking union sets the scene for banks to merge across borders. It has opened up a large pool of potential partners.

Cross-border mergers would do more than just help the banking sector to shrink. They would also deepen integration. And this would take us closer to our goal of a truly European banking sector. Savers would have more options when investing their money, and companies could tap more sources of funding. Risk-sharing would be improved, and the economy would become more stable and more efficient. At the same time, European banking supervision would continue to ensure that cross-border banks are properly supervised.

As for the banks themselves, they would also benefit, of course. They would be better able to diversify their portfolios and achieve economies of scale. They would become more efficient and more profitable.

All this makes mergers seem like something we should see more of – both domestic and cross-border. But in fact that’s not what we see. Since 2007, mergers and acquisitions in the euro area have actually declined. In 2016, they reached their lowest level since 2000, both in terms of the number of deals and their value.[7] And those mergers that we do see are domestic rather than cross-border.

So what is keeping banks from merging? There are some general issues which might explain why banks are a bit reluctant to merge at the moment.

First of all, bank mergers are complex, expensive and risky. So they require an adventurous spirit, a clear vision and a strong will. Banks need to be very confident if they are to take such a step. And it seems that they are currently lacking confidence in a lot of things. Uncertainty prevails.

Banks seem to be unsure of the economic value mergers would generate. Looking at potential partners, they might have doubts about the quality of their assets and their ability to generate profits. In some parts of the euro area, non-performing loans are still high and their true value hard to assess. At the same time, a bank’s ability to generate profits hinges on its ability to adapt its business model. And this is also hard to assess.

On top of this, banks also seem to be uncertain about structural issues. How will digitalisation affect the optimal structure and size of a bank, for instance? Is it still worthwhile to acquire branch networks when digital banking might make them less and less useful? Banks also seem to be uncertain about regulation, in particular about Basel III. Basel III has been in the making for almost a decade now, and it still needs to be finalised. It seems that many banks would like to see the rulebook in its final form before they consider taking the big leap of merging with another bank.

Turning to cross-border mergers, things become still more uncertain. First of all, such mergers require banks not only to go beyond national borders, but also to overcome cultural and linguistic barriers. This adds to the risk of cross-border mergers.[8]

And then, there are still uneven patches on the playing field. Tax codes and legal systems, for instance, differ between countries. And so does banking regulation – despite the single rulebook. These differences might also make cross-border mergers less appealing as they prevent banks from reaping the full benefits.

Given all these uncertainties, banks seem to have turned inwards. They are trying to adapt their business models, cut costs, tackle legacy assets and reap the benefits of digitalisation – all while dealing with tougher rules. It seems that, for the time being, banks see more merit in getting their own houses in order rather than buying additional houses.

But still, mergers can do more than just helping to shrink the banking sector. They also offer major benefits for banks themselves. And the banking union has paved the way for cross-border mergers. All that’s missing is brave banks that will set sail to explore and conquer this new territory.

What is the role of regulators and supervisors?

Now let’s turn back to consolidation and tackle the final question for today: is there anything regulators and supervisors can do to help the banking sector shrink?

Frankly, our role is limited. Consolidation should be left to market forces. This links back to something I said before. A properly functioning market should automatically find the right level of consolidation.

Our role is rather to create the conditions that allow the market to do its job. This includes setting up the Single Resolution Mechanism that I already mentioned. But there are also some steps that we can take to reduce unnecessary barriers to mergers. Let me give you a few examples.

We can, for instance, help to reduce the uncertainty about the quality of banks’ assets. The asset quality review we performed in 2014 was a first step towards that goal. And our work on non-performing loans will take us another step forward. Addressing legacy assets will have two effects. First, it will make mergers more attractive; and second, it will enhance banks’ capacity to take them on.

Another item on the list should be to create regulatory certainty. I have said it many times before, and I will say it again: Basel III needs to be finalised sooner rather than later. And then it needs to be implemented in a consistent manner.

And then, as we are now more like a single jurisdiction – thanks to the Single Supervisory Mechanism – we have to ensure that domestic and cross-border banking groups are treated in a consistent way. That’s why we support the European Commission’s proposal to grant capital waivers within banking groups on an EU cross-border basis, and not just locally, as is the case now.


Ladies and gentlemen,

Voltaire said: “Use, do not abuse; as the wise man commands. Neither abstinence nor excess ever renders man happy.” However, it is one thing to realise that we have too much of a good thing. Doing something about it is another thing entirely. This requires a strong will and a lot of discipline.

In the banking sector, market forces impose the necessary discipline – if they work properly. It is the job of regulators and supervisors to ensure just that: a properly functioning market. And we have come a long way towards that goal.

There is a good chance that the banking sector will indeed shrink. All banks need to review their business models. Some of them might become leaner as a result, others might merge and others still might fail. The result will be a right-sized banking sector that can reliably serve the economy.

Thank you for your attention.

  1. Brasky, T.M., White, E. and Chen, C.L. (2017), “Long-term, supplemental, one-carbon metabolism-related vitamin B use in relation to lung cancer risk in the vitamins and lifestyle (VITAL) cohort”, Journal of Clinical Oncology, published online before print, 22 August 2017.
  2. Berger, A.N., Klapper, L.F. and Turk-Ariss, R. (2009), “Bank competition and financial stability”, Journal of Financial Services Research, Vol. 35(2), pp. 99-118.
  3. Goldin, C. and Katz, L.F. (2008), “Transitions: Career and Family Life Cycles of the Educational Elite”, American Economic Review: Papers and Proceedings, Vol. 98(2), pp. 363-369; Bolton, P., Santos, T. and Scheinkman, J.A. (2011), “Cream skimming in financial markets”, NBER Working Paper, No 16804.
  4. Gambacorta, L., Yang, J. and Tsatsaronis, K. (2014), “Financial structure and growth”, BIS Quarterly Review, March 2014.
  5. Arcand, J.L., Berkes, E. and Panizza, U. (2015), “Too much finance?”, Journal of Economic Growth, Vol. 20(2), pp. 105-148; Cecchetti, S. and Kharroubi, E. (2012), “Reassessing the impact of finance on growth”, BIS Working Papers, No 381.
  6. European Systemic Risk Board (2014), “Is Europe overbanked?”, Reports of the Advisory Scientific Committee, No 4, June 2014.
  7. ECB (2017), Financial Integration in Europe, May 2017.
  8. Weber, R.A. and Camerer, C.F. (2003), “Cultural conflict and merger failure: an experimental approach”, Management Science, Vol. 49(4), pp. 400-415.

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