Europe’s banking industry is in good shape. After a sustained period of low interest rates, the continent’s financial services groups are enjoying healthy profits and strong earnings growth. Despite sluggish economic performance in the eurozone, many banks are performing well because of continued demand for products such as mortgages and consumer loans, while loan-loss provisions are still at historical lows.

Nevertheless, there are some potential dark clouds on the horizon. Low long-term interest rates has encouraged growth in lending, fuelling property booms in countries such as the UK, Spain and France, and helping fund private equity buy-outs and – more recently – increased corporate takeover activity.

As overall debt levels rise, loan growth looks set to slow while provisions for bad debts may begin to rise. At the same time, the flattening of the yield curve could squeeze some banks’ profitability.

As John Tiner, chief executive of the UK’s Financial Services Authority, recently said to an audience of bankers: “The banking sector has, of course, been incredibly strong – but then this may be as good as it gets.”

At the same time, fundamental long-term barriers to cross-border competition mean the dream of a truly pan-European market in financial services remains some way off. Although Santander Central Hispano’s takeover of Abbey National in 2004, and UniCredito’s purchase of HVB this year have prompted predictions of a wave of banking consolidation, deals have so far proved elusive. Meanwhile, the continuing existence of national legal structures, different frameworks for protecting consumers, and protectionist domestic regulators have made it difficult for Europe’s banks to offer cross-border retail financial products on a large scale.

In the past year, the attention of Europe’s bankers has been focused on Italy, where ABN Amro of the Netherlands and BBVA of Spain each tried to buy a mid-sized bank. After extraordinary resistance from the Bank of Italy, ABN Amro appears to have succeeded, but BBVA was defeated by a rival bid from Unipol, a small Italian insurer.

The experience has helped inject a note of scepticism into the enthusiastic predictions that a wave of cross-border consolidation was about to be unleashed on Europe’s banks. The prices of smaller banks that could be takeover targets, such as Germany’s Commerzbank, have been pushed up, but so far deals have remained elusive. Meanwhile, issues such as location of headquarters and the distribution of cost savings continue to complicate discussions about mergers between larger banks. Perhaps most crucially, as most banks continue to predict relatively strong earnings growth, few feel they need a partner.

“Although a true cross-border merger of equals between two strong performers cannot be ruled out, we believe that most of the best-performing banks are not ready to give up control,” analysts at Standard & Poor’s, the credit rating agency, wrote in a recent report. “Taking into account the small number of weak and available targets in Europe, we believe that most players will continue to seek alternative stand-alone growth opportunities before envisaging being acquired.”

Indeed, most European banks have responded to the difficulties of consolidating at home by pursuing acquisitions in emerging markets where growth rates are attractive. They have pursued a wide range of targets, from Barclays’ takeover of Absa in South Africa to Fortis’s acquisition of Disbank in Turkey. Others have sought growth in eastern Europe, with seven of Europe’s banks initially contesting the auction of BCR in Romania. Another popular destination for overseas investment has been China and several banks have bought minority stakes in Chinese lenders.

Despite the expectations of sluggish growth at home, predicted growth rates for banks in Europe remain well ahead of forecast GDP growth. Analysts at Keefe, Bruyette & Woods, a boutique specialising in financial services, estimate that earnings at Europe’s banks will grow by 14 per cent in 2005, falling to 11 per cent in 2006.

Within these figures there are important regional distinctions. For example, most investors believe loan growth in the UK will slow as consumers reach the limits of indebtedness. Indeed, analysts at Citigroup calculate that in June, loan growth in Europe overtook loan growth in the UK for the first time in five years,

In other countries, particular sectors such as demand for mortgages are expected to rise as a result of deregulation.

Credit Suisse First Boston analysts recently forecast that, by 2010, the French mortgage market would have a ratio of mortgages to GDP of 55 per cent, up from 29 per cent today and compared with 65 per cent in the UK. “In general, the less restrictive and more open the mortgage market, the greater the propensity to consume,” they wrote.

In countries such as the UK where demand for debt is reaching its limits, retail banks are concentrating on restructuring their branch networks to sell a broader range of products to existing customers.

Other forms of regulation are also proving important. After years of discussion, the European Commission recently approved the final version of the Capital Requirements Directive, which enshrines the principles of the Basel II framework for banks’ capital in European law. Banks will not start adopting the rules until early 2007, but they are busily making the transition. Though it is too early to say what effect the rules will have on banks’ capital, analysts are already predicting that Basel II will help drive consolidation because it rewards banks for diversifying their capital bases.

While mass retail financial services remain firmly rooted within borders, European banks are successfully creating pan-European and sometimes global businesses in certain specific product lines. These include areas such as wealth management, which is enjoying strong growth as investors seek a safe home for their money. Economies of scale in back-office functions such as technology are helping larger institutions take market share from smaller rivals.

Wholesale banking is also proving increasingly important for Europe’s banks. Barclays, Royal Bank of Scotland, BNP Paribas and Société Générale have all expanded their investment banking businesses in recent years, helped by the growth in demand for fixed income products and equity derivatives. In some parts of Europe, corporate loan growth has picked up the slack where demand for consumer loans has been weak.

Another area where some banks have emerged as pan-European leaders is consumer finance. SCH of Spain and BNP’s Cetelem subsidiary have successfully expanded across borders to offer products in countries where they are not supported by a retail network.

Despite their recent growth record, investors continue to give banks low ratings on the stock market, suggesting they are suspicious that the rapid expansion is storing up future problems. Bankers insist their risk management skills have improved and the use of sophisticated balance sheet management techniques such as securitisation and buying credit default swaps means risk is now much more evenly distributed throughout the financial system. Yet until the banking system is forced to weather an increase in long-term interest rates, investors are likely to remain wary.

Besides, even if banks can avoid large losses resulting from a collapse in house prices or a sudden increase in unemployment, they will still have to work out a way of achieving growth in a more difficult environment.

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