Why European banks are less profitable than U.S. banks: A decomposition approach

The low profitability of European banks relative to their U.S. counterparts has recently raised concerns among policy makers and researchers. This paper attempts to shed light on this issue by using the O'Donnell (2012)decomposition approach. This approach enables us to decompose the relative profitability of European banks into an output-input price index and a total factor productivity index, with the former further decomposed into two price indexes and the latter further into four productivity and efficiency measures. Our results show that European banks' profitability was not only weak, but also deteriorated over time. Our further analysis shows that the decline in the output-input price index was due to declines in relative lending rate and relative return on securities and an increase in funding costs, while the decline in the productivity index was driven by declines in technical efficiency, scale efficiency, and residual mix efficiency.