The European banking sector has witnessed a resurgence in profitability throughout 2023 and into 2024, reaching heights not seen since the onset of the Financial Crisis in 2007.

As reported by the European Banking Authority, the average return on equity for European banks has consistently exceeded 10% during this period, a marked improvement from the previous decade, where returns lingered between 0% and 8%.

This revival in profitability can be primarily attributed to the interest rate hikes implemented by central banks in 2022, which restored rates to pre-crisis levels. These increases allowed banks to charge higher borrowing rates and to achieve a margin over deposit rates that compensates for the liquidity risks involved in financing long-term mortgages with short-term debt. This recent favourable development, however, cannot hide ongoing structural problems of the European banking sector. 

While the increased returns may appear encouraging, they merely bring banks in line with the expectations of investors. For much of the past decade European banks have underperformed in this respect, as the return expectations of investors in this sector (measured in terms of the sector-specific ‘cost of equity’) have consistently been at the level of 10% according to the ECB. The gap between realised returns and the cost of equity helps to explain why market values have been well below book values in recent years, as seen in the UK, for instance. This prolonged underperformance has placed European banks at a disadvantage compared to their U.S. counterparts, which have recovered more swiftly from the Global Financial Crisis 2007-2008 and have yielded higher returns on equity since then. 

Unfortunately, the sustainability of the recent profitability surge is uncertain. A recent study by the International Monetary Fund (IMF) warns that the current levels of bank profitability in Europe may be short-lived. Analysing data from over 2,500 European banks, the IMF expects that returns are likely to decline in the near future as central banks are anticipated to lower policy rates. Additionally, the IMF highlights the risk of rising default rates on bank loans, as borrowers who took on debt during the period of elevated interest rates may struggle to meet their financial obligations. 

The IMF report points out deeper structural challenges that continue to hinder the European banking sector from achieving high and sustainable profitability levels. Among the most pressing concerns are overcapacity and low operational efficiency. To tackle these challenges, mergers and acquisitions (M&A) could help to streamline operations and reduce excess capacity. Simply waiting for inefficient banks to exit the market is unlikely to be effective, as regulators and politicians often aim to prevent outright bank failures due to prudential concerns. Additionally, the reluctance of many bank customers to switch providers reduces competitive pressures on underperforming banks. Following the Global Financial Crisis, the appetite for acquisitions within the European banking sector was limited, as most banks were focused on recovery rather than expansion. However, the sector’s current strength owing to favourable market conditions could reignite interest in M&A. And the recent news of UniCredit’s investment in Commerzbank might signal the start of this development.

Whether actual opportunities for M&As will materialise depends on approval by competition authorities. In a recent report on the evolution of competition in the EU, the European Commission expressed some scepticism about increased concentration in the banking sector, citing a study that suggests mortgage rates are higher in countries with higher levels of banking concentration. But this study only presents a correlation for seven European countries in a single year and its findings should therefore be interpreted with caution. 

Potential consolidation in the banking sector will be scrutinised not only by competition authorities but also by financial regulators, who may be concerned that merged banks could become "too big to fail". When mergers remains below this critical thresholds, however, they can positively contribute to financial stability by enhancing efficiency and reducing overcapacity. More profitable banks are better equipped to absorb economic shocks. Cross-border mergers could strengthen the financial system in particular, as they break the vicious cycle in which banks heavily concentrated in a single country are disproportionately affected by that country’s economic crises, becoming unable to provide the necessary funding for recovery from these crises. By diversifying their activities across multiple countries, banks could reduce their vulnerability to localised economic downturns, while countries would benefit from having access to funding from a more diverse set of banks spread across different regions. To facilitate the development of such cross-border mergers, a completion of the European ‘Banking Union’ may be beneficial, as it would lead to harmonised regulatory frameworks across countries.

In conclusion, the recent surge in profitability in the European banking sector might only be temporary, but it could provide a good opportunity to tackle long-lasting, structural problems. Strategic mergers could play a helpful role in this respect by reducing overcapacity in the sector and boost efficiency, thereby paving the way to sustainable profitability in the future.