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Global investors seem to be getting bullish on banks Stateside, but the European banking system is still falling behind.
Plagued by a number of factors such as an ultra-loose monetary policy environment, high levels of non-performing loans, uncertainty caused by the U.K.'s vote to exit the European Union and massive fines, the European banking industry has a long way to go in order to catch up with its American counterparts.
Recently, for the first time since the financial crisis, the U.S. Federal Reserve did not object to any of the capital plans of 34 banks it reviewed in the second part of the annual stress tests implemented in the wake of the crisis. U.S. banking stocks rose sharply after the Fed announced its review. The impact was seen in Europe as well where bank stocks rose more than a percent following the optimism of their peers Stateside.
"The big U.S. banks will get bigger," David Coker, lecturer in accounting, finance and governance at Westminster Business School, told CNBC via email.
Coker, who is also a former vice president of global risk management at Deutsche Bank, added that share prices of American banks were already surging in expectation, and the combination of share repurchases and dividend hikes will make future capital raises much easier.
Big banks like JPMorgan and Citigroup announced their largest ever stock repurchase program of $19.4 billion and $15.6 billion respectively. Buybacks occur when firms purchase their own shares, reducing the proportion in the hands of investors. Like dividend payments, buybacks offer a way to return cash to shareholders, and usually, see a company's stock push higher as shares get scarcer. Citigroup also doubled its dividends while Bank of America and Morgan Stanley hiked their quarterly dividends to 12 cents a share and 25 cents a share, respectively.
"Profitable banking is all about economies of scale; as the U.S. banks get bigger, costs will continue to tumble and a virtuous cycle realized," Coker said.
Coker thinks that driven by Brexit uncertainty and a need to maintain continental access, we will see more American banks going on a "shopping spree."
"Again, in mergers and acquisitions (M&A), size matters. To get an idea of just how large American banks are, a single U.S. bank such as JP Morgan is larger than the combined capitalization of banks in Spain, Germany, France and Italy."
European banks are constantly shrinking in size. Blame it on the financial crisis, the low-interest rate environment or the massive fines that these banks have had to incur, but the sector is gradually starting to lose its charm.
Globally, banks have paid about $321 billion in fines since the 2008 financial crisis as regulators have stepped up scrutiny, according to a note by the Boston Consulting Group. North American banks accounted for nearly 63 percent of the total fines as U.S. regulators have been more effective in imposing penalties and recovering fines from the banks compared to their counterparts in Europe and Asia. But the gradual rate hike path from the U.S. Federal Reserve has eased the pressure on the profitability of American banks. Rising rates are good for banks since they are able to lend out money to investors at a profitable rate of interest. Lower interest rates restrict the bank's ability to make profits thus adding pressure on margins.
In the last year, lenders like RBS, Credit Suisse, Deutsche Bank and BNP have announced their plans to close operations that they see as less profitable. Banks across Europe have also seen mergers and consolidation, especially in Spain and Italy in order to save banks from going bankrupt, which could lead to a bigger systemic risk across the region.
"Consolidation in Spain and Italy represents a risk to the acquiring banks, and was driven by necessity," Colin McLean, managing director at SVM Asset Management, told CNBC via email.
"I expect more bail-ins to resolve problems. Only good targets for acquiring banks are those with significant deposit bases and limited legacy and nonperforming loan (NPL) problems. Some form of EU Troubled Asset Relief Program (TARP) is still possible for banks on the periphery with impaired loans, if the European banking association can persuade Germany of it."
A bail-in is rescuing a financial institution that is ailing and on the brink of a crisis. It generally happens before bankruptcy such as in the case of Banco Popular in Spain. This, however, is different from a bailout where external parties such as a state government may rush to rescue a financial institution using taxpayers money. A bail-in is seen as an alternative to a bailout - the use of state funds to help out an ailing bank. A bail-in is the rescue of a financial institution by making its creditors and depositors take a loss on their holdings.
The last few months have seen a number of European banks and governments take on a different approach in order to avert yet another banking crisis. Recently, Spanish lender Santander agreed to buy domestic rival Banco Popular for a symbolic price of one euro after the European Central Bank declared the latter was "failing or likely to fail."
"The significant deterioration of the liquidity situation of the bank in recent days led to a determination that the entity would have, in the near future, been unable to pay its debts or other liabilities as they fell due," announced the ECB in a statement last month.
Following on from this, the Italian government decided to wind down two failed regional banks last month in a deal that could cost the state up to 17 billion euros ($19 billion), leaving the lenders' good assets in the hand's the nation's biggest retail bank, Intesa Sanpaolo.
The government is set to pay 5.2 billion euros to Intesa, and give it guarantees of up 12 billion euros, so that it will take over the remains of Popolare di Vicenza and Veneto Banca, which collapsed after years of mismanagement and poor lending.
Just a week after that, the Italian government swooped in to save another bank. Finance Minister Pier Carlo Padoan announced earlier last week that the government had received approval from the European Commission to pump 5.4 billion euros into Banca Monte dei Paschi di Siena (BMPS) in exchange for the lender undertaking a major restructuring overhaul.
While these developments in the last few months have led to a rally among European stocks, it has also highlighted the trend of consolidation and mergers that the European banking space is moving towards.
"This is clearly necessary, but only if the sector also downsizes to an appropriate level," University of Westminster's Coker told CNBC.
"Europeans are notoriously overbanked on many levels. Consolidation is meaningless if economies of scale aren't pursued. While there has been downsizing post crisis, more must be done. At the same time we need to see European SMEs (small to medium-sized businesses) pursuing market driven sources of capital rather than relying solely upon bank finance. Both will drive borrowing costs down," he added.
While the European banking sector is plagued with uncertainty, a number of analysts think that there is no way out unless the banks start to clear out their non-performing loans. The biggest problem of non-performing loans in Europe can be seen in Italian banks with loans estimated to total around 360 billion euros ($401 billion).
Coker explained that presently the Italian NPLs roughly triple the EU average.
"The fundamental problem seems to be the courts – a bankruptcy can take almost eight years to clear, and we have seen some cases drag on for decades. This helps nobody. Many NPLs are routinely carried at 30 percent or so of face value, however investors are willing to pay perhaps 10 percent. While we are seeing some entities enter into deals with third parties (e.g., UniCredits' $20 billion bad loan sale to Pimco), perhaps half of all NPLs are unsecured."
He further explained that a recovery is uncertain so banks are sometimes loathed to realize losses. "The Italian government has to take a hard line, and make balance sheet cleansing a priority," he offered.
But with the Italian government taking on a strong fast-track approach to solving the banking crisis, there seems to be some hope for the European banking sector in general. The latest move towards consolidation and mergers have also helped offset factors such as low interest rates and massive fines. The road however is still tough ahead.
"Things won't get better until European banks substantially clear NPLs and begin to aggressively cut costs," Coker said.
He further explained that the most challenging bit is that cost cutting isn't proceeding at an acceptable pace, and there are divergences between hard and soft data even as central banks globally are shifting to policy stances of less, not more, accommodation.
"Of course a steeping yield curve favors banks, however, the impact of the first interest rate hikes in almost a decade can't be forecast with certainty."
Despite the looming NPL crisis, some analysts remain hopeful. "There should be some improvement over the next year as Europe's recovery gathers steam. But NPL problems in the periphery and the ailing mutual need to be addressed," SVM's McLean said.
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