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Capital punishment: Why it's 'Live, Debt, Repeat' for Europe's banks

Last year's Tom Cruise movie "Edge of Tomorrow" also sports the tagline "Live, Die, Repeat," and its time-loop plot mirrors "Groundhog Day," where weatherman Bill Murray gets to repeat each day.

But in the Cruise film, the story is darker and requires him to battle aliens, each day learning from the experience and getting a little further towards the last scene where the conflict is finally won.

Step forward Europe's banks. They have been struggling to adjust their legacy business models to the "new normal" of lower interest rate margins and weak economic activity since 2008. For Europe's bankers, the ghosts of the Great Financial Crisis of 2008 are yet to be vanquished. Rebuilding business models, capital levels, and deleveraging and paying fines for misdeeds has been an annual preoccupation since the crisis seven years ago.


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Unfortunately, just like the "Edge of Tomorrow," 2016 will be a replay of this year with the same disappointing conclusions for investors. And for those waiting for a credit-led, bank-driven, growth recovery in Europe – don't hold your breath. In two important respects, 2016 could actually get quite a bit worse for the bankers.

The first problem is capital. The regulator's desire to prevent further bank failures continues to raise the bar for capital levels banks must hold. A recent JPMorgan Cazenove report estimated a €26 billion ($27.5 billion) shortfall by 2018 in 35 major European lenders if proposed Common Equity Tier 1 capital ratio levels are implemented. This would require banks to dispose of or relabel some of their assets to meet the targets.

While the European Central Bank (ECB) has suggested new rules due for completion next year should not result in higher capital needs for euro zone banks, there is still uncertainty about the outcome of the Basel III deliberations on capital adequacy, stress-testing and market liquidity risk for banks.

The ECB is also pushing forward its new definitions of capital to 2018, which would have an effect on how banks use deferred tax assets and holdings in insurance subsidiaries to meet capital requirements.

Astonishingly, 7 years after the global financial crisis European banks are still sitting on a trillion euros of non-performing loans. The European Banking Authority says these represent 7.3 percent of the European Union's gross domestic product. These debts are a dead weight, like handicapping a horse in a Derby, they limit the pace at which credit can be extended to new businesses and hamper the accumulation of growth capital. Under-capitalised banks do not lend money readily, or pay dividends, and management concerns about regulation will encourage them to be conservative in their approach.

Beat Wittmann, of TCMG and Dynapartners puts it bluntly: "Banks will have to further deleverage, raise capital and sell assets, and an acceleration can be expected in 2016." He also worries about the business environment the banks are being forced to operate in as the ECB tries to stimulate economic activity through monetary policy.

"The lowering of interest rates again by the ECB could trigger another round of changes in banking sector business models, strategy and consolidation. If the ECB sets rates even lower, the margin pressure on traditional bank businesses will finally reach real pain levels for some," he says.

It's unlikely that relief on interest-rate margins will come for some time. As long as the ECB is still fighting deflation to achieve its price stability mandate, and aspires to a 2 percent inflation goal, interest rates are set to remain on currently ultra-low levels for the next few years. It's also possible that rates are cut further at the December 3 meeting as bank president Mario Draghi and the governing council at the ECB decide "doing whatever it takes" means another round of action, in part to mitigate the anticipated tightening from Federal Reserve "lift-off".

Recent high-profile management changes at Credit Suisse, Deutsche Bank, and Barclays have signalled a desire to make progress with new business models. But in some important respects Europe's banks are lagging behind their US counterparts.

Signs of strength typified by healthy cross-border capital flows and the passage of weak to strong is lagging. Banking sector consolidation still has a way to go in the small and medium-sized space, and on a pan-European basis between large entities.

Whether they are focused on asset management, retail banking or investment banking, banks will have to think hard and act accordingly to generate revenues and profits, as non-profitable banks are no longer tolerated. As Beat Wittman sees it, "systemically relevant universal banks have so far employed the 'last man standing' strategy, however, with the 4th capital raising round some casualties might emerge."

In the "Edge of Tomorrow," Cruise destroys the alien core and, despite apparently dying in the attack, wakes the next day to a world that has changed for the better and the demons have been vanquished. Europe's bankers would like their own legacy challenges to evaporate in 2016. Only in this case, life just ain't like Hollywood.

Geoff Cutmore is co-anchor for CNBC's flagship programme Squawk Box Europe.

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