The Outlook For Europe's Banks

The proposed Deutsche merger with Commerzbank is just the start of a long, painful process for Europe

- Howard Chua-Eoan and Pat Regnier

The world’s largest money manager has a stark warning: More than a decade after the global financial crisis, European banks still face a long and tortuous path to recovery. “Europe is in the midst of a painful, painful transition,” Philipp Hildebrand, vice chairman of BlackRock Inc., said on Bloomberg TV. “I would expect it to entail significant changes in the way banks operate, in their business models, and it will take time.” Until then, he said, investors will probably steer clear. That the region’s financial institutions,

including some of the biggest, are in a state of grinding decline is a grave cause for concern—and not just for their stockholders and bondholders. Europe relies heavily on its lenders to fuel growth. Banks provide about three-quarters of financing to companies and nine-tenths of credit to households. In the U.S., corporations rely on capital markets—selling bonds and shares—for the bulk of their financing.

Indeed, part of the pressure on Deutsche Bank AG and Commerzbank AG to consider a merger came from parts of the German government that very much want a healthy national financial champion to help accelerate the country’s flagging growth. But there’s no easy fix. Both banks are struggling with their own overhauls, and even if they can manage the tens of thousands of job cuts that would likely come with a marriage, it’s not clear that a bigger entity would be significantly stronger.

With economic expansion sputtering not only in Germany but also across the European continent, time may be running out for banks to heal themselves. Another recession would complicate their turnarounds. At the heart of the difficulties are weak balance sheets and modest profitability. Many banks are still just barely able to cover their cost of equity— that is, what investors seek as compensation for companies’ perceived risk.