PARIS French banks, their metamorphosis from battered euro-crisis victims to European outperformers complete, now risk being outgunned as rivals take more radical steps to drive profits and deal with rules on capital.
Shunned as pariahs two years ago for their exposure to trouble spots such as Greece and Italy, French bank stocks have been the picks of Europe over the past year, outperforming the sector .SX7P by around 30 percent after shedding risky assets and boosting their capital defenses.
There may still be some share price upside left, some investors say, as the banks launch fresh plans to cut costs and as the eurozone hauls itself out of recession. But any enthusiasm is tempered by concerns the French banks have yet to carve out a competitive niche that can withstand increased regulation and market jitters linked to higher interest rates.
"The Greek problem has been taken care of (and) exposure to Italian debt has been cut across the board," said Frederic Rozier, a fund manager at Meeschaert Gestion in Paris.
"The French banks have realigned themselves ... But with interest rates on the rise, a potential property correction ahead and mounting regulation, there is still a question mark over the business model to choose."
Over the past 18 months, BNP Paribas (BNPP.PA), Societe Generale (SOGN.PA) and Credit Agricole (CAGR.PA) have cut a combined 100 billion euros ($131.9 billion) in assets from their risk-adjusted balance sheets.
But even as they broadly cut risk, the French - helped by a resilient home market and an accommodating regulator - have avoided radical change of the sort carried out at the likes of Royal Bank of Scotland (RBS.L) and UBS UBSN.VX, who have exited business lines and adapted to post-crisis conditions under pressure from regulators and investors.
The result is that French banks have stayed conservative on their outlook. While UBS and HSBC (HSBA.L) are targeting returns on equity of up to 17 percent and 15 percent respectively by 2015, SocGen is eyeing 10 percent within the same timeframe. BNP has declined to even set a profit target until next year.
"The French banks will soon have to start looking for growth levers now that they are on the path to normalization," said Yannick Naud, portfolio manager at Glendevon King in London.
BNP and SocGen are talking up their geographic footprint: the former is seeking to expand in the United States, Germany and Asia, while the latter is trumpeting its exposure to non-euro economies like Russia and eastern Europe.
But some say that despite pockets of strength in equity derivatives and euro bonds, these banks lack a competitive edge.
"We don't think SocGen has a business model that is profitable enough or differentiates itself enough," said Espirito Santo banks analyst Shailesh Raikundlia. "As for BNP, which seems to be focused on growing the business ... I'm not sure the market is looking for banks to expand."
Part of what used to set French lenders apart before the financial crisis was their access to pools of talent from the nation's elite engineering academies, who found they could make more money building complex financial options and structured products than making bridges and trains.
But over the past five years, the "French touch" has become more synonymous with market failures than lucrative equations: Jerome Kerviel's rogue trades at SocGen, Fabrice Tourre's conviction for mortgage fraud at Goldman Sachs (GS.N) and Bruno Iksil's alleged "London Whale" losses at JPMorgan Chase (JPM.N).
French banks themselves have become more risk-averse, shuttering proprietary trading desks and focusing instead on sleepy but cash-rich retail banking to boost profits. While this has helped cushion losses from whipsawing financial markets, retail is now stagnating and branches are being shut.
"(SocGen's) line is radically different from what it used to be ... The days when SocGen was the most aggressive in corporate and investment banking are over," said Bruno Bernstein, fund manager at Keren Finance in Paris.
"What used to set the French banks apart was the maths-whiz side, that ability to structure complex products," Bernstein added. "I don't see any appetite today from private or high-net-worth clients for that sort of thing."
Despite the recent run-up in their share price, French banks are still valued only broadly in line with the sector, with price-to-tangible-asset ratios of between 0.6 to 0.8 versus a European sector average of around 0.7.
French banks have also benefited from their regulator's relatively flexible approach to capital and leverage.
Unlike whip-cracking watchdogs in Britain and Switzerland, France's ACPR has publicly opposed going beyond minimum capital rules for its own banks and was seen as instrumental in watering down the government's bank-reform law last year.
While Britain's regulator has put banks under pressure to meet new rules on leverage, prompting Barclays (BARC.L) to announce a 5.8 billion pounds ($9 billion) rights issue, the ACPR has publicly slammed analyst reports that say Credit Agricole and SocGen face capital holes.
"French banks have reached or are not far from reaching the leverage ratio ... They should be able to avoid the scenario of having to raise capital," top ACPR official Frederic Visnovsky told newspaper Les Echos in August.
Such a stance is good news for French banks, argues Espirito Santo's Raikundlia. "You can see why the French banks are happy," he said. "There is a very low risk of the French regulator asking banks to raise capital."
But there is a question over whether the regulatory approach will stay the same when the European Central Bank takes over direct supervision of the bloc's top banks late next year.
In the meantime, French lenders run the risk of falling into complacency - until the market next tests them.
And with the U.S. Federal Reserve already signaling the era of ultra-cheap cash may be coming to an end, some investors believe now is the time for the French banks to make tougher decisions on hiving off business lines and refocusing on less capital-intensive operations to appease market concerns.
"Banks have been basically getting their main commodity for free," said Meeschaert's Rozier. "Choices will have to be made." ($1 = 0.7582 euros) ($1 = 0.6425 British pounds)
(Editing by Carmel Crimmins and David Holmes)