The banking business has fallen on hard times. The combination of persistent low interest rates, increasing regulatory compliance costs, and the rise of new competitors taking advantage of financial technologies (fintech for short) has produced, in Europe in particular, excess capacity and low profitability - and a strong temptation to merge.
In a difficult market, mergers - by enabling banks to cut costs, share information-technology platforms, and increase market power, thereby relieving pressure on margins and rebuilding capital - make sense. And the banks know it. Witness the recent merger talks between Deutsche Bank and Commerzbank, both of which have faced huge declines in market capitalisation.
So a wave of mergers may be on the way. The question is whether that approach really can solve banks' problems and benefit society.
To be sure, mergers and acquisitions (M&As) are not always a matter of escaping trouble. In fact, M&A activity - both the number and size of transactions - was picking up before the 2008 global financial crisis, including across borders within and beyond the eurozone. After peaking in 2007, such activity diminished, as domestic restructuring took precedence, particularly in countries such as Greece and Spain, which had to implement difficult adjustment programmes.
Moreover, the M&A approach does not always work. In October 2007, a consortium formed by the Royal Bank of Scotland (RBS), Fortis, and Banco Santander acquired ABN AMRO - the world's biggest bank takeover to date. RBS and Fortis failed soon after and had to be rescued.
Nonetheless, supervisory bodies favour mergers to save banks in trouble. Competition authorities tend to be more reluctant, recognising the danger that large-scale mergers can consolidate an anti-competitive market structure, while creating even more "too big to fail" banks that may cause financial instability in the future. But they are often overruled or compelled to acquiesce. The US Department of Justice (DoJ) agreed to the merger between Wells Fargo and Wachovia, among others, soon after the 2008 financial crisis, and the UK Office of Fair Trade (OFT) was overruled in the merging of HBOS and Lloyds.
Competition is not the only source of merger-related tension among authorities. There is also friction between national supervisors, who prefer domestic mergers, and supranational supervisors, who prefer cross-border mergers within their jurisdiction (the eurozone, in the European Central Bank's case). The benefits of cross-border consolidation are that market power is diluted in a large market, and more diversification is obtained, though these gains come at the price of weakened cost synergies.
From the banks' perspective, cross-border mergers may potentially be the better option, as long as they occur within a single supervisory framework. That way, they can benefit from common supervision and resolution. The eurozone's new supervisory framework, supervised by the European Central Bank (ECB) and possessing a common resolution authority, reflects this recognition of the benefits of cross-border mergers.
But Europe lags when it comes to such mergers, owing to a broader lack of financial integration. Indeed, in the European Union (EU), member countries' own banks tend to be the dominant players in the domestic market - say, BNP Paribas in France or UniCredit in Italy. In the United States, by contrast, the same large banks - such as Bank of America, JPMorgan Chase, and Wells Fargo - tend to dominate a large number of different states.
US banks have had more space to diversify. For European banks - which must navigate vast differences in culture, language, and law in pursuing cross-border mergers - this has been much more difficult, especially because many of them also need to cut overcapacity drastically. As a result, in the near term, European banks are more likely to pursue domestic - or, at most, regional - consolidation.
For the United Kingdom, which voted in June to "Brexit" the EU, the situation is particularly complicated. The UK long benefited from an open policy on acquisitions by foreign banks, which allowed, for example, the Spanish Santander Group to bid for Britain's Abbey National in 2001.
But Brexit will probably move supervision of UK-based banks out of the EU framework, raising the cost of cross-border deals and implying a loss to British consumers. As the UK banking sector's competitiveness suffers, the temptation to return to the kind of light-touch regulation that enabled the crisis in the first place could intensify.
As for the rest of Europe's banks, now might be the time to consider the merger option. Mergers are no silver bullet, but they could help to alleviate serious problems relatively quickly - though, in the longer term, the banks would still have to tackle the legacy of heavy and rigid structures and rebuild their reputations, with a strong focus on consumer service and fairness.
At the same time, if a merger strategy is to work for the good of society, competition must be preserved. If incumbents simply continue to get larger, blocking new competitors from entering the market, they will end up facing intrusive regulatory compliance programmes and higher capital requirements. New market entrants would have more flexibility and thus might be able to offer new, more appealing deals to customers.
This is why bank supervision and competition policy must work in tandem to ensure a level playing field. On one hand, regulations must apply to all firms performing banking functions, including new fintech institutions. On the other hand, implicit subsidies to too-big-to-fail banks must be dropped.
Bank mergers hold much promise, particularly in Europe. To realise their potential will require the right policy mix, focused on consumer protection and fair competition. Europe's banks and banking authorities will need to step up their game.
Xavier Vives is Professor of Economics and Finance at IESE Business School and the author of Competition and Stability in Banking. Project Syndicate. e-mail: 2016. www.project-syndicate.org