Why the banking sector is better, but with room for improvement (Part 3 of 5)
However, now for the bad news: We only moved our outlook up to a benchmark weight for two reasons:
1.) More work still needs to be done in shoring up the European banking sector. US banks are in better shape, and are further along in the recapitalizing and deleveraging processes than European banks. In addition, relative to the size of their respective economies, the European banking sector is considerably more leveraged than the US one, meaning additional deleveraging by European banks will hinder their profitability.
In addition, the European economy is more dependent on bank lending. In Europe, 81% of corporate borrowing uses bank intermediaries versus 16% in the United States. As such, slower European economic growth, related to deleveraging, will likely lead to lower earnings for European banks.
The bottom line: The gap in profitability between European and US financials is unlikely to close anytime soon (the return on equity for the US financials sector is currently 8.2% as compared with 4.5% for the European sector).
Market Realist – The graph above shows the return on equity for the top European and U.S. banks (XLF) in 2013.
U.S. banks like Citi (C), JP Morgan Chase (JPM), Bank of America (BAC), and Wells Fargo (WFC) have displayed strong returns on equity in 2013. On the other hand, HSBC is one of the very few European banks to show stable profitability.
The U.S. economy has been stable since 2010, while Europe has seen the Euro debt crisis and reeled from a double-dip recession. European banks haven’t had a chance to recover. This is the reason for their low profitability.
According to a report by Deutsche Bank (DB), loan growth too has been favorable in the U.S.—especially in the corporate lending sector. This is another area where the European banks lag severely.
Read on to the next part of this series to see how regulations could affect bank profitability moving forward.
Browse this series on Market Realist:
- Part 1 - Why the banking sector is better, but with room for improvement
- Part 2 - More profitability means a better outlook for the financial sector
- Part 4 - Must-know: Why regulations could affect bank profitability
- Banking & Budgeting