The Curious Case of Europe's Shrinking Banks

Europe's largest financial institutions, which have been readjusting since the onset of the 2008 financial crash and the sovereign debt crisis that followed, are causing pain all over the globe that will have long term implications, according to analysts. They argue that the situation will only worsen without the proposed European banking union.

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European banks have been scaling back as new regulations come into force aimed at preventing another crisis. Swiss bank UBS has downgraded its global ambitions by shrinking its investment banking units. Lloyds bank announced last year it was to pull out of its overseas lending and French banks BNP Paribas, Credit Agricole and Societe Generale have been busy stripping their assets away in countries like Greece and Egypt.

"At the moment what we have is an undoing of the cross border integration process that we had over the last twenty years. Banks are not lending in other countries," Alberto Gallo, senior credit strategist at RBS told CNBC Thursday.

"Now we have the 'Benjamin Button' syndrome, day by day Europe is becoming younger and coming back to a more isolated financial market."

(Read More: Investment Banks Facing Slump in Once-Promising Emerging Markets)

The Basel III banking regulation is due to be phased in over the next few years which will give banks new rules on capital requirements, leveraging and liquidity and critics have suggested that these new rules are slowing the recovery from the euro zone debt crisis.

French banks are the perfect example of this new inward looking trend, according to Paul Donovan, global economist at UBS. The knock-on effect is that project funding in China, Vietnam and the Middle East over the next five years will suffer.

"What we're seeing is the French banks pulling out of the Middle East, the French banks pulling out of Asia, the globalization of capital is being reversed by the French government saying 'You've got to come and fund our deficit'," he told CNBC.

"So the problem isn't the deficit, as I say, it's the implication of funding that deficit at home that means you get less globalized capital, you get less internationalization, you get a less efficient economy globally coming out of this."

(Read More: Hollande Unveils Softened French Bank Reform)

This change in structure means banking systems such as France's are becoming more "parochial" Donovan said.

Finance ministers from the euro zone reached a deal on December 13 on rules for around 200 banks to come under the oversight of the European Central Bank, which will act as chief supervisor. The proposals for the union can't be implemented fast enough according to Donovan.

"What we have got is a promise for the future, which is great, as good as any politician's promise is going to be," Donovan said.

"Pick a year when that is going to happen though?"

(Read More: Banking Union: First Step to Two-Speed Europe?)

The union is also set to include a common deposit guarantee and a resolution framework that would manage how a banks are dealt with is another crisis occurs. And it's the former that Gallo says could prove problematic.

"In practice it's very hard to get because effectively a deposit guarantee fund is a liability and it requires a stronger step towards fiscal union and core European countries are very opposed to that," he said.

"Without a banking union it risks basically localizing every country and going back to where we were fifteen years ago."

By CNBC's Matt Clinch