By Huw Jones
LONDON (Reuters) - Banks in the European Union could close branches, merge or leave the market to reverse a "bleak" outlook for profitability, the bloc's banking watchdog said on Friday.
The European Banking Authority's (EBA) sixth annual dive under the bonnet of top banks found that the average capital ratios for lenders - a key measure of financial health - was 14.4% in June, little changed from the previous year.
The percentage of poorly performing loans on bank books has fallen to an average of 3%, down from 3.6% a year earlier, but the return on equity worsened to 7% from 7.2%, still below the average cost of equity, the EBA said.
"There are hardly any clear catalysts for an improvement in bank profitability that appear on the horizon," the EBA said in its report.
"Low profitability limits banks' capacity to generate capital organically and to fund loan growth as well as to pay dividends."
(GRAPHIC: EBA Graphic - https://fingfx.thomsonreuters.com/gfx/mkt/12/9326/9238/EBAgraphic1.png )
Only 28% of listed EU banks trade with a price-to-book ratio of more than 1 or where market value exceeds net assets, the EBA said. The equivalent for U.S. banks is 81%.
Banks need to streamline operating expenses to lift profitability, such as by merging with a rival or leaving the market if they can't generate sustainable profits, it said.
Deutsche Bank (DE:DBKGn) is among European lenders seeking to boost their financial health and this week sold $50 billion in unwanted assets to Goldman Sachs (N:GS) as part of a lengthy restructuring.
Consolidation in banking, however, has been on a declining trend since a peak in 2007.
Staffing continues to account for the biggest share of operating expenses at 54%.
There is also a question of whether the EU is delivering on its pledge to create a single market for banking, given that some rules present potential obstacles to cross-border banking activity and cross-border consolidation, the EBA said.
The low density of bank branches in Nordic countries and high levels of automatisation have also helped banks to put a lid on costs.
"This might suggest that banks could streamline their operating expenses by rationalizing their branch networks, among other measures," the EBA said.
Banks in Britain have closed more than three thousand branches in the past four years as more people bank online, though lawmakers have said that this has left rural areas poorly served.