Painful 2013 leaves European banks' returns well below target

* ROE in 2013 was 6.6 percent across top European quoted banks

* Bank ROE level about 40 pct of wider market returns

* Cost/income ratios better, but hit by loan provisions, fines

* Rising capital requirements dilutes returns

* Gap (Frankfurt: GAP.F - news) between high-return Nordics and others narrowing

By Laura Noonan

LONDON, April 17 (Reuters) - Europe's largest banks are generating a poor return on their capital, well below their post-crisis targets, as muted credit growth slows their recovery and progress on costs is swallowed by unexpectedly high loan losses.

The data shows that in 2013 the top 30 listed banks improved their cost/income ratios, an efficiency yardstick, despite billions in fines and provisions for a string of scandals, but with return on equity (ROE) so weak, investors could take some convincing that their risk profile is low enough to compensate.

Two thirds of the banks have set medium-term numerical ROE targets, all aiming for at least 10 percent, most for 12 percent or more, and some for 15 percent or "mid teens".

While they typically are giving themselves until 2016 to hit their goals, progress is slow. They achieved just 6.6 percent in 2013, according to Reuters calculations of a simple average for the 26 that disclose the figures. For 2012 it was 3.9 percent.

That is a long way from the glory days before the collapse in the U.S. subprime mortgage market turned the banking world upside down. In 2006 the group enjoyed an average ROE of about 19 percent, including 36.4 percent for Spain's BBVA (Amsterdam: BBV.AS - news) , 25.5 percent at Lloyds and 24 percent at Bank of Ireland (Other OTC: IRLD - news) .

Permanently higher levels of capital, imposed by regulators after many banks were laid low by the financial crisis, mean ROE is unlikely to hit those levels again, since higher equity dilutes the return, but investors want to see more progress.

"(ROE) remains way too low, considering how undercapitalised many European banks remain," said Charles de Vaulx, chief investment officer at New York (Frankfurt: HX6.F - news) -based International Value Advisors, which has about $18 billion under management.

Ian Scott, head of European equity strategy at Barclays (LSE: BARC.L - news) , who nevertheless counts himself a buyer of banks for their potential for improvement, said the stock market as a whole managed an ROE two and a half times higher than the banking sector.

If EU-wide stress tests later this year conclude that banks need yet more capital to deal with future crises, ROE will fall lower still.

De Vaulx thinks that will make some of the targets too ambitious.

"Over the medium term, 10 to 12 percent seems a lot more realistic than mid teens, in our opinion," he said.

ECONOMIC RECOVERY

Mark Denham, a London-based European equities fund manager at Aviva Global Investors, said share prices for banks had already had a good run, boosted by the anticipation of economic recovery, and he couldn't see an obvious driver for continued outperformance.

"I either think a decent improvement in return on equity has been factored in now, at these prices, or even if that isn't the case, stocks have performed so well, I would be reluctant to add to them here," he said.

Notable stock market gains so far this year include 38 percent and 31 percent for Italy's Banco Popolare (Dusseldorf: B8Z.DU - news) and UniCredit (Berlin: CRIH.BE - news) and 23 percent for Banco Comercial Portugues .

"I prefer to look for companies with high and sustainable profitability," said Denham, "and I think the banks have demonstrated over the last cycle that they don't exhibit those characteristics."

Some are more positive. "We would be a buyer of banks," said Barclays' Scott. "We and the consensus expect the return on equity of the banking sector will recover and that the gap between the banking sector return and that of the rest of the market should narrow over the next few years as we see loan-loss provisions come down, probably quite sharply, and we should also start to see some improvements in loan growth."

A MIXED FIELD

The figures illustrate a significant divergence in ROE across the pack, with Nordic (SES: MR7.SI - news) banks including Swedbank , Handelsbanken and DNB (Other OTC: DNBHF - news) already close or at the mid teen mark, while others including the UK's Barclays and Austria's Erste are at or below 1 percent.

Kian Abouhossein, head of European banks' research at JP Morgan (Other OTC: MGHL - news) , said last year's returns were depressed by unexpectedly high charges for scandals such as interest rate fixing and mis-selling, and because euro zone banks wrote down loans ahead of an ECB test that will determine whether their assets are properly valued.

He expects ROE to rebound at retail and southern European banks this year, but still short of target, given the limited scope for granting new loans in those economies and continuing high loan losses.

"For domestic business in Spain, return on equity is not going to be at 10 percent," he said. "For Italy, it will be below 10 percent (in 2014) and 10 to 12 percent in a normalised environment. For Portuguese banks, you're looking at close to break-even (for 2014)."

Those countries' top listed banks' return on equity last year ranged from 2.98 percent at Banco Popular Espanol to 5.61 percent at Bankia (Madrid: BKIA.MC - news) . Abouhossein said banks had some scope to make further cost cuts, particularly once economies improve, but that the key factor would be loan loss provisions.

Last year, their cost/income ratio was 60.9 percent, against 62.7 percent for 2012, indicating some progress is being made. A banking source pointed out that most banks' ROE targets were based on their continuing or core businesses, whereas current ROE was being dragged down by the run-off of troubled loans and discontinued business areas.

"The question is the quality of return on equity," said Abouhossein. "Are we going to get less and less volatility and standard deviation in the return on equity? ... Will it be between plus 15 and minus 15 percent, or between 17 and 10 percent? It will be an interesting discussion point, but we probably won't get to a conclusion until we have the next crisis." (Reporting By Laura Noonan; Additional reporting by Joshua Franklin and Simon Jessop in London; Editing by Will Waterman)