European banks struggle behind US counterparts

European banks are lagging behind US peers in reducing balance sheet leverage and reliance in wholesale funding, a new European Central Bank report has found.

European banks are lagging behind US peers in reducing balance sheet leverage and reliance in wholesale funding, a new European Central Bank (ECB) report has found.

The ECB has looked into the structural changes made in the euro banking sector from 2008 to 2012, and identified some key distinguishing features between European and US banks.

The report found that the performance of large US banks improved after the financial crisis as a result of lower loan losses, stable fee and commission income, and higher trading income. 

“Euro banks, on the other hand, are still struggling with weak profitability and losses caused by the second, euro area-focused wave of the global financial crisis,” it said.

The size and structure of domestic banking sectors, which differs substantially, comes into play when comparing US and eurozone banks, the report said. In the euro area, domestic banking sector assets are close to 270% of GDP in Estonia and over 400% of GDP in Cyprus. The figure in the US is about 72%.

According to the report, the differences in size could be attributed to three main factors: the greater role of bank versus capital market-based intermediation in the euro area economy; the relatively higher importance of the shadow banking system in the US; and differences in the accounting standards in use in the US and Europe. 

Traditionally, there is greater reliance on bank financing in the euro area, whereas non-bank intermediaries have a more important role in the US. Capital market-based funding for non-financial corporations, for example, is higher in the US.

“In the United States, bank loans account for only 20% of total corporate debt. This stands in stark contracts to the euro area where loans from monetary financial institutions account for close to 50% of total corporate debt.”

The share of total loans in euro area banks’ assets has remained broadly unchanged since the financial crisis, while it decreased in the US. 

As for wholesale funding, the difference between the euro area and US banks remained significant, which is related to lower non-bank intermediation in Europe. There were also differences between US banks’ leverage ratios due to regulation on capital requirements, the report said.

“There is some evidence that euro area banks tended to have a higher share of assets with a low risk weight, allowing them to report strong capital ratios under Basel II rules.

“By contrast, US banks have traditionally been subject to binding leverage ratios and the less risk-sensitive Basel I requirements, which may have led them to focus on assets with higher returns,” the report said. 

HFT trading  

The ECB also released a working paper called ‘High frequency trading (HFT) and price discovery,’ which found there was no evidence that HFT contributed directly to market instability in prices. 

“On the contrary, HFTs overall trade in the direction of reducing transitory pricing errors both on average days and on the most volatile days during a period of relative market turbulence,” the report said.

HFTs have a beneficial role in price discovery. “They reduce the noise component of prices and acquire and trade on different types of information, making prices more efficient overall.”

The report concluded that introducing measures to curb traders activities without corresponding measures to that support price discovery and market efficiency improving activities could result in less efficient markets.