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Is Europe overbanked?

According to an ESRB report the European banking system is abnormally bloated and therefore risky. This problem reflects various causes like government support, inadequate prudential supervision and the promotion of “national champions”…

Advisory Scientific Committee, report no. 4
2 June 2014
European Systemic Risk Board

The ESRB report was written by a group of the ESRB’s Advisory Scientific Committee, which comprised Marco Pagano, Sam Langfield, Viral Acharya, Arnoud Boot, Markus Brunnermeier, Claudia Buch, Martin Hellwig, André Sapir and Ieke van den Burg.


This paper is after a difficult question: has banking grown too much in Europe? The difficultly of the question lies in the words “too much”, which require a normative answer. We must take a stance on how much is “too much”, based on the needs of the real economy in Europe.

To tackle the question, we take an approach similar to that of a doctor treating a patient who seems overweight. The doctor’s first step is anamnesis: to collect information about the patient’s current and past weight and their medical history; and to benchmark these data against those of other people. Likewise, in Section 1 we review basic facts about the banking system in Europe, including its size, recent growth, concentration and leverage, and compare these data with those of other banking systems. According to all indicators, our patient is abnormally heavy.

The doctor must then make a diagnosis: as to whether the patient has gained “too much” weight, in the sense of weight gain leading to problems such as high blood pressure, sleep and breathing difficulties, and so on. Similarly, in Section 2 we explore whether the European banking system has expanded beyond the point where it makes positive contributions (at the margin) to the real economy. Specifically, we investigate whether banks’ recent expansion is associated with (i) lower and more volatile economic growth; and (ii) excessive risk-taking and more frequent financial crises, including banking and sovereign debt crises.

At this point, the doctor considers why the patient has gained so much weight, i.e. turns to etiology: is it eating disorders, a sedentary lifestyle, or a disease? This question is asked not just out of curiosity, but because these causes entail different prognoses regarding the future of the patient’s health and different therapies. Similarly, Europe’s overbanking problem reflects various causes (described in Section 3): (i) government support and inadequate prudential supervision have exacerbated banks’ moral hazard problems; (ii) politicians in some countries have encouraged such expansion, for instance to promote “national champions” or to stimulate employment growth for electoral reasons; and (iii) the cost mix of European banks may have induced banks to overextend their market presence.

Finally, after gathering and evaluating all the evidence, the doctor prescribes therapies for the sorry patient. The objective of therapy is to address the root causes of the illness; alleviate nasty symptoms; and avoid unintended side-effects. Likewise, in Section 4, we outline possible policies to address overbanking in Europe.

We are not the first doctors that the European banking system has consulted in recent years. Our patient has just taken a potent medicine (the CRD IV package) and has prescriptions for more (BRRD, SSM, SRM, and possibly structural reform).1 Indeed, our patient has grown tired of this medicinal onslaught: he has “therapy fatigue”. But, in our view, more is needed. Some therapies could have a higher dosage; others have not been tried at all. We think that a course of new treatments will brighten the prognosis: helping the European banking system to make a speedy and lasting recovery from its current bloated state.

First part from Section 4

Before turning to policy remedies, it is worth summarizing the main findings of this report. We began by showing that over the past 20 years (and particularly since 2000) in Europe the banking system has grown much more than elsewhere. European banks have also become considerably more concentrated, and have expanded into activities beyond traditional relationship lending. In particular:

  • The European banking system has reached a size where its marginal contribution to real economic growth is likely to be nil or negative. It is associated with real imbalances such as over-investment in housing and diversion of talent from non-financial sectors. Bloated banking systems also tend to be riskier, both in terms of individual bank risk-taking and banks’ exposure and contribution to systemic risk. As a result, bloated banking systems have the potential to cause and exacerbate banking and sovereign debt crises (Section 2, Part A).
  • The large size of Europe’s banking system also translates into a financial structure in which securities markets are less important in the financing of the real economy. Over the past 15 years Europe’s bank bias has increased, bucking the global trend. This is a matter of concern because financial structures heavily skewed towards banking are associated with lower economic growth (Section 2, Part B).
  • The universal bank business model – whereby a bank performs both traditional financial intermediation and securities market activities such as designing, underwriting, holding and trading marketable securities, especially derivatives – is widespread in Europe. Universal banking is generally justified on the basis of economies of scope, but is also likely to find its rationale in the ability of universal banks to operate in securities markets with funding costs that reflect their retail banking status. Public subsidies (deposit guarantees, creditor guarantees, and privileged access to central bank funding) give universal banks a competitive advantage over non-bank institutions. At the same time, the universal bank business model is a source of fragility, because it is associated with higher levels of systemic risk exposure and contribution at the bank-level, threatening systemic stability (Section 2, Part C).

Overbanking is not just a European problem: many of the symptoms associated with it are also present in other countries. And many of the factors that may have contributed to it, such as financial innovation and lenient prudential regulation, are present worldwide. Yet the evidence indicates that the situation has become particularly serious in Europe. Why?

Risk-taking incentives due to moral hazard may be higher in Europe because of greater perceived propensity of European governments to bail out “too big to fail banks”, in turn due to the lack of crisis, management and resolution tools in the pre-crisis era; more fragmented and less effective supervision; the pervasiveness of the universal banking model; and the process of financial integration. Moreover, in European countries the relationship between politics and banks has contributed to the emergence and abnormal growth of mega-banks because of politicians’ propensity to rescue zombie banks by merging them with healthier ones and their desire to create and support “national champions” capable of withstanding Europe-wide competition. Politics may also have directly contributed to the excess risktaking of banks, via the appointment of incompetent managers (Section 3).