Over the past 15 years, European banks have made substantial progress in restructuring and fortifying their operations to withstand the next financial crisis. This progress has largely been driven by stringent measures from European Union (EU) banking regulators.

But the focus on the health and resilience of banks, in an economy with anemic growth, has left its mark on the competitiveness of the European banking sector. European banks’ market valuations are languishing below book value and declining relative to their US counterparts.

The Single Supervisory Mechanism (SSM), the first pillar of the 2012 European banking union initiated to bolster bank resilience, has been pivotal in strengthening and promoting financial stability in the region. But the SSM’s mandate does not extend to supporting bank competitiveness or ensuring that bank capital helps drive economic growth across the region. Critics argue that this is an incomplete view of bank resilience that has placed an artificial cap on bank performance and valuation.

Recalibrating for economic growth in Europe

The strategic challenge is not invisible to policymakers. Two recent reports on competitiveness by former Italian Prime Ministers Enrico Letta and Mario Draghi, the latter of whom is also a former President of the European Central Bank, advocate for the promotion of European banks that are large and competitive enough to be relevant on the global stage. These banks, they argue, can provide competitive financial services to the region and strengthen the autonomy of the common market, whose companies and investors are increasingly reliant on US banks and capital markets.

Maria Luís Albuquerque, the new European Commissioner for Financial Services and the Savings and Investments Union, has acknowledged the need for a unified European strategy that extends beyond the banking sector. The EU is slipping further behind the US in economic growth and investment in strategic sectors, including artificial intelligence (AI), renewable energy, and biotechnology. This is partly due to higher energy prices in Europe driving away energy-intensive activities like generative AI, and partly due to onerous regulatory requirements across industries stifling innovation and small business formation.

By contrast, the new US administration appears to be readying a comprehensive assessment of regulation, bureaucracy, and anything perceived to stand in the way of commercial progress. This comes at a time when Europe desperately needs to attract institutional capital to supplement investment from strained national budgets and capital-constrained banks.

The EU banking sector predominantly relies on traditional loans to meet about 70% of corporate financing needs. However, access to these types of loans is becoming increasingly encumbered due to stricter regulations and rising interest rates. Meanwhile, capital markets aren’t a viable alternative. They are even harder and more expensive to access thanks to the absence of a single market for capital (equity or debt) that would allow investments and funding to flow more easily across the region.

Key changes needed to reform the EU financial sector

While the need for reform is clear, significant regulatory hurdles and political obstacles remain. Our expectation is that the EU will make only incremental progress toward its ambitious goals for the banking and financial services sectors. That said, the competitive pressure created by the aggressive stance of the new US administration could drive more fundamental change. Three such shifts would make the biggest impact.

1. Rethinking regulation

A structural shift in financial and corporate regulation aimed at bolstering bank competitiveness, directing capital to strategic sectors, and fostering high-growth, innovative businesses that attract capital could be transformative. This would require simplifying the capital framework, ensuring coherence across capital and liquidity buffers, increasing transparency, and reducing red tape.

2. Promoting consolidation

Consolidation would allow the emergence of several European champions with the scale to compete across products and geographies as well as provide competitive financial services across the region. There has been a strong bias against bank consolidation in Europe and across the world since the global financial crisis. Within Europe, the bias against cross-border consolidation is even stronger. Making bank consolidation work will take more than a mindset shift; it would require the harmonization of regulations and supervision, and most likely the implementation of a liquidity backstop that would cross borders.

3. Achieving a true banking and capital markets union

A genuine commitment to a capital markets union would allow European firms to compete on equal footing with the US across public equity and debt capital markets. Creating a European regulatory body like the Securities and Exchange Commission tasked with promoting securities investment throughout the region would help cultivate a more homogeneous and integrated investment environment, facilitating smoother capital flows and greater market efficiency across Europe.

This article is part of our Known Unknowns report highlighting the debates that will shape the future of financial services