Crashing markets and a stalled economic recovery are starting to hit banks, causing problems which will make them vulnerable to acquisition.

A wave of cross-border mergers and acquisitions is due to hit Europe. Much anticipated and long delayed, it looks to be the result of crisis situations caused by plummeting markets and a deteriorating economic scenario, instead of primarily a search for increased revenue and lower costs in a single European Union financial market, as had been expected.

Even as markets see the slowest mergers and acquisitions activity in years, a combination of the tardy recovery, a pipeline of bad debts and the credit squeeze will sort out the wheat from the chaff, and lead to a rearrangement of the banking scene in Europe.

With the FTSE-100 at a six-year low, the S&P500 at a five-year low and Continental stock markets following the plunge over the cliff, opportunistic buying is now the name of the game. Taking advantage of a peer's or a competitor's predicament may lead to different combinations than those predicted scarcely 12 months ago. Nonetheless, a few hurdles have yet to be cleared, such as the German elections on September 22, although others could vanish: regulators may be willing to clear deals to bolster troubled banks, putting to one side their concerns about the impact on competition or the creation of national champions.

"You will see a couple [of mega-European] mergers on the Continent coming up sooner than expected, partly driven by the balance-sheet impairment from the recent financial markets turmoil,'' says Herman Hintzen, head of the European financial institutions group at Credit Suisse First Boston. "A strong capital base and annuity-like earnings are at a premium.''

At this point, it is not yet clear which are the troubled banks. There are some indications - Abbey National in the UK, Credit Suisse in Switzerland - but these are just the tip of the iceberg.

"There are more bad debts to come out as we are not yet at the bottom of the cycle,'' says Martin Taylor, chairman of Goldman Sachs Asset Management International. "The state of the markets means companies cannot or will not raise equity, and some are over-geared despite low interest rates.''

France Telecom is a classic case of this. Its situation has become so dire that the French government is considering renationalising it. Yet banks are not only exposed to this sort of companies - they also have loans outstanding or are holding securities from companies which, from one day to the next, are reclassified by rating agencies as junk, such as Vivendi Universal, the media group. On one day in July, its shares fell 25.5% after being downgraded by rating agency Moody's - highlighting another stumbling block for banks: the dire state of the markets.

Market pressure

This affects them in up to three ways, depending on what sort of businesses they own. Firstly, those with investment banking arms are suffering. Healthy debt issuance, now tailing off, is not making up for a dearth of mergers and acquisitions business, while it is not yet obvious how far the fast-growing structured finance business may be affected by the collapse of Enron and WorldCom. The few share issues announced are being delayed, so fees from the equity side of that business look to fall even further than they have over the last year.

Secondly, profits from those with fund management arms are diminishing. In the UK - which dominates asset management - profit margins fell by an average of nearly one-third last year, from 33% to 23%, among a group of 24 fund managers with a total of £1100bn in assets, according to a study by accountancy firm PricewaterhouseCoopers (PwC). Retail fund management businesses saw their profits almost halve from 42% to 24%. This year looks to be even worse.

Meanwhile, in Europe as a whole, profitability fell by an average 34% as private banks saw their revenues tumble by 14%, according to the latest Global Wealth Survey from Boston Consulting Group.

Finally, those with insurance arms are being forced to bolster them. Credit Suisse in June announced it was putting Sfr1.7bn into insurance arm Winterthur, while the UK's Abbey National paid £150m to strengthen the finances of its life assurance arm, Scottish Mutual. If the bear market continues, more capital may have to be pumped into them, or they may be sold (see page 34).

"We are working with more than one client seeking to restructure its life business,'' says Gregg Sando, global head of the financial institutions group at Deutsche Bank.

However, bancassurance combinations are still viable because channels to market are so dominated by the banks in many Continental European countries, says Paul Wilson, head of the financial services practice in London for Bain, the management consultants.

Meanwhile, the emerging market jitters are beginning to spread beyond Argentina into Brazil as it faces October elections, while Mexico's dependence on the (faltering) US recovery is making it less attractive than at the beginning of the year. This affects both BBVA and SCH, the big Spanish banks, suffering from their exposure to Latin America as investors shun risk, as well as banks specialising in emerging market bonds as the market dries up.

A bear market can also help convince investors and management. "Shareholders are happy to coast as long as share prices are rising, even if the bank boards don't have a convincing strategy. But [low markets] help focus the boards on whether there is a viable value-creating strategy,'' says Rana Talwar, former head of emerging market bank Standard Chartered.

Pressure on margins and higher bad debts may force management to seek a merger or an acquisition. Also, lower share prices mean that one of the deterrents to an acquisition - a high premium - disappears. Basel II may also lead big banks to use the benefit of their lower capital requirements to buy small banks.

Still, the issue of keeping costs down remains imperative. "The game is advancing. Financial institutions are developing flexible technology platforms that can support pan-European products such as mortgages, credit cards, consumer loans and even pensions. The players that are first in building cross-border product platforms will be the winners in the inevitable European consolidation phase,'' says Mr Sando.

This troubled world does not necessarily mean banking crises of the sort that would see runs on banks or jeopardised deposits. "Banks have spent 10 years being over-capitalised,'' says one banker. "Since then, they have done two things. They have continued being disintermediated by the capital markets and have sold credit risk to insurance companies and pension funds, other than in Germany and Japan.''

But just because banks have lower non-performing loans ratios than in the aftermath of the last recession does not mean they will be free from them. Crowing about the enormous improvement in their risk systems may yet prove premature, especially as nervous investors tend to shudder at the slightest increase in non-performing loans (NPLs).

Weak markets give retail a boost

Consolidation will also be helped by the weak markets as banks realise that bull market businesses - wealth management and brokerage, among others - will take longer to yield returns, shining a light back on basic retail banking, says Walid Boustany, head of group strategic planning at HSBC Holdings.

In some markets such as Italy, which has 936 banks, there is room for more domestic consolidation, although the regulator is making it difficult. But in others, either competition issues or structural issues are stopping it, or a mopping up operation involving smaller banks is not worth the trouble.

Nonetheless, the same argument holds true: market conditions will make authorities more amenable. Who could doubt that if Lloyds TSB were bidding for troubled Abbey National now the deal would go through without a hitch, rather than being disallowed on competition grounds, asks one banker.

Also, in a recent McKinsey paper that looked at European bank M&A in the five years to 2000, the consultants found in their sample of 98 transactions, including by chance an equal number of value-creating as value-destroying transactions, that "what seems to be absolutely crucial for successful M&A transactions is to find a significant cost efficiency potential and a profitability gap to be realised as the basis for value creation".

This implies a merger with a bank that needs to increase the return on its assets in the normal course of business, but also makes troubled banks even more interesting.

So who are the consolidators? The 15 mentioned (see box on page 18) are by no means exhaustive, they are simply the ones that have expressed interest or look most set to act.

The advantages

 Although the opportunities arising out of the bear market may provide the catalyst for cross-border mergers in Europe, some of the basic reasons for them are not market related:

Competitors: "If a major deal gets done to create a new bank north of euro 75bn - about euro 35bn is currently the European market capitalisation of some major banks - that will be a catalyst,'' says Dominic Casserley, head of European banking and securities at McKinsey & Co. "It would create a rush to the exit as people don't want to be left out of the party.''

Cost: "The value created in a cross-border merger differs materially from domestic mergers. You can cut 5% to 7% off the cost base versus 15% to 18%. Only now is this relevant due to the lower cost [and interest rate] ambience,'' says David Rhodes at the Boston Consulting Group.

History: "Big banks over a sustained period of time have not managed to grow organically in mature markets. They are much better at merging to cut costs,'' says Mr Rhodes.

Euro: The arrival of the euro is driving the move to a single financial services market.

Size: Brings economies of scale. Especially by merging capital markets or mortgage arms cross-border or credit cards.

Investors: As long as a merger is well-presented, with detailed and believable objectives, the market will buy it. Banks that are perceived as being good at integration, such as BNP Paribas, have a head start.

The impediments

Nonetheless, some of the impediments have not materially changed:

Competitors: Banks too often follow each other over the cliff. (See history below).

Cost: The amount of management time that has to be devoted to the merger often leads to the eye being taken off the ball.

History is littered with mergers that have not worked. This is especially true when it is a merger of equals rather than a clear-cut takeover, but outright cross-border takeovers are politically awkward in Europe.

Euro: "My hope is that within five years we will have a lot of cross-border mergers. We have the euro but we are dependent on governments for the harmonisation of regulation and taxation. Till then, the advantages for shareholders are not obvious,'' says Michel Pébereau, head of BNP Paribas.

Size: "Banks should be breaking up, not merging. The search for synergies has come at some cost,'' says Mark Weil, a director at consultant Oliver, Wyman, pointing to US monoline success stories such as Capital One, the credit card company.

Investors: "Only when fund managers are judged against a Euro-index rather than national indices, when the benchmarks become European [will you see major cross-border mergers],'' says Jonathan Dawson, a managing director at Lazard.

US potential

In addition to Europe, the fragmented US market is very attractive for some of the European players. ABN Amro, HSBC, Royal Bank of Scotland, BNP Paribas and Allied Irish Banks have all been buying up banks there.

"There is a lot of scope to expand once you have a foothold,'' says one banker.

Robert Albertson, principal and chief strategist at boutique US investment bank Sandler O'Neill, believes European banks can add value. "If you know how to run a mortgage-type business in Europe then you can do it in the US. If you know how to run a credit card business in Europe then you can do it in the US,'' he says.

The difficult market conditions will make US banks more vulnerable, arguably even more so than European ones.

"It is more feasible to find attractive businesses in the US because returns are generally higher than in Europe. However, US banks often leverage their capital more fully, and manage very close to full capacity by seeking the last dollar of ROE,'' says HSBC's Walid Boustany.

"There is a greater appetite in the US for wholesale funding to extend credit risk, or issuing paper to make acquisitions. To take undue risks and expect to get away with it is far less feasible in today's markets, except for the stronger world-class players,'' he adds.

HSBC has substantial operations in the US and has stated it is looking for others. So are other banks.

"The banks [in the US] are cheap,'' Emilio Bot'n, chairman of SCH, told The Banker in March. Markets have fallen further since then.

All of this is not to say the impediments are vanishing overnight. After all, low markets could prove to be barriers to some deals, as well as making them happen. Fears of finding skeletons in the closet of a potential partner are a function of the times. Den norske Bank reportedly pulled out of buying Storebrand because of larger-than-expected loan losses in its private banking unit. And navel-gazing, rather than bold actions, can be a chief executive's reaction to major uncertainty.

However, opportunities thrown up by the current climate may prove irresistible. In fact, Storebrand is now a merger candidate for a foreign bank, since at this point, the Norwegian government has agreed to relax ownership rules for financial institutions.

One banker at an American investment bank, after listing the reasons why the markets would not accept a deal, admits: "Clearly, CEOs do remain interested in big mega-merger ideas. There have been exploratory talks and they are keeping an eye on it.''

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