The European Central Bank is keen to see consolidation among the region's top banks but others believe headwinds around the banking union and political uncertainty may delay any deals. Stefanie Linhardt reports.

Europe big fish

Much has been written and talked about in recent months regarding potential mega-mergers in the European banking sector. But so far, the results have been underwhelming. No large mergers and acquisition (M&A) deals have taken place among Europe’s banks, despite a pick-up in M&A in other sectors.

So will the remainder of 2018 bring the large, transformational cross-border transactions in the European banking sector – or is it all much ado about nothing? Who, and what, is actually driving these deals and what are the challenges along the way?

Nothing to see here

It is a decade since the onslaught of the global financial crisis and the European banking sector is still less integrated than before the Lehman Brothers collapse – at least, that is what May’s Financial Integration Report from the European Central Bank (ECB) shows. The price- and quantity-based financial integration composite indicators that the ECB has calculated show that by the end of 2017, integration in both areas still fell short of year-end 2007 data, although the price-based index has been steadily increasing since mid 2016.

The banking union has been a supportive factor in improving financial integration through the benefits of the single supervisory mechanism and single resolution mechanism. But analysis by research assistant Inês Gonçalves Raposo and director Guntram Wolff at Brussels-based think tank Bruegel show “there are no signs that [pan-European] merger activity has changed since the beginning of the banking union”.

Stefano Combi, managing director for financial institutions at HSBC sees three categories of banks where potential M&A could come from: “The first group are banks with relatively strong capital positions, contemplating M&A in search of top line growth, and as a means to achieve critical mass in their core markets. The second group might still have to re-focus and therefore engage in exiting specific operations to focus on core markets. The third group is focused on improving their asset quality positions by reducing non-performing assets - both organically and inorganically - to help achieve a normalised return on equity [ROE] and, in turn, an upside in their valuations,” he says.

Too much improvement?

Of the potential mega-mergers that have hit the headlines, a combination of Italy’s UniCredit and France’s Société Générale would, with $2.5bn equivalent, create Europe’s largest bank by assets (some $20m ahead of the current largest, HSBC) when adding up reported year-end 2017 figures.

UniCredit’s chief executive, Jean-Pierre Mustier – formerly SocGen’s investment banking head – is an outspoken supporter of consolidation. At the meeting of the Institute of International Finance in Brussels in May, he called for “more pan-European banks” of a larger scale.

But little seems to have happened since. Where are the widely rumoured large mergers in Europe’s banking sector? And who is pushing for consolidation?

Max Mesny, co-head of financial institutions group for Europe, the Middle East and Africa (EMEA) at Credit Suisse, says: “The level and intensity of dialogue around M&A options has increased significantly over the past 12 months. That is a result of banks’ capital positions, balance sheets and operations having improved.” 

He says on average, cost-to-income ratios have come down, capital deployment is more disciplined and there has been investment in technology across banks. “We are looking at a bank landscape of a much better quality and, as a result, executives are looking at their portfolio of activities and at where areas of better returns and growth could be.” 

Potential Euro MandA

Synergies and shareholders

One obvious catalyst for increasing returns is cost cutting, which in M&A can be achieved through synergies. At a time when ROE at most banking groups in Europe is significantly lagging behind that of other geographies, the prospect of higher returns through economies of scale could also motivate shareholders or activist investors in a lender to encourage top management to consider consolidation.

According to Patrick Sarch, partner and co-head of White & Case’s financial institutions global industry group, pressure from stakeholders is increasing. “We are seeing [activism and shareholder pressure] in a number of obvious banks but there is a lot more going on behind the scenes. People have been talking about it for years [but] it is now everywhere,” he says.

Carlo Messina, chief executive at Intesa Sanpaolo, Italy’s second largest bank by assets, is not interested in large international or domestic M&A but believes a second wave of consolidation will come in Europe. For any potential merger, “a pre-condition” is the approval of its shareholders, he notes, and this can only be achieved if “the project you propose brings earnings per share accretion”.

But creating synergies, cutting costs and boosting returns is not always an easy task. There is a need for a significant overlap in business models or geographies to allow for cost savings, and M&A initially comes with additional costs, not savings.

New clients and products

But what if the two businesses have different business models? In the case of the rumoured merger of Deutsche Bank and Commerzbank, the resounding argument supporting a combination of the two differing models is that it would provide Germany’s largest bank with scale in the retail and small and medium-sized enterprise market, which it is currently lacking.

Following this rationale, another key reason for merging is to gain access to new or complementary products and services, customers or technology. Cost-cutting potential in a Deutsche/Commerzbank transaction could be high due to them sharing the same jurisdiction – but it is not true of every merger. Sometimes parts of a combined business are subsequently divested, however.

Also, asks Sam Theodore, head of financial institutions ratings at Scope Ratings in London, at a time when the EU’s revised Payment Services Directive has established ‘open banking’, to what extent do banks still need to acquire clients and services through M&A if they could just use digital services to expand into a new jurisdiction or product range?

“This environment creates more question marks about the need to invest into significant cross-border acquisitions or mergers,” he says. Mr Theodore believes senior management at large institutions are not the driving factor behind a push for large-scale bank M&A. There are three other instigators: sell-side analysts and hedge funds; the financial media; and European supervisors, especially the ECB.

“If you look at the European banking sector, it has been pretty much static since the crisis and a lot of people would like to see movement,” he says. “Most news on the banking sector is old, related to non-performing loans [NPLs] and low margins. M&A creates news.”

The ECB, meanwhile “would very much like to [see] the conviction that the European banking union is here to stay,” adds Mr Theodore. “The more European cross-border transactions there are, the more these transnational banks of the future will need a pan-European supervisor, the more the role will be enhanced.”

The ECB has indeed been vocal on bank consolidation. In September 2017, the chair of the ECB’s supervisory board, Danièle Nouy, made the case for fewer banks within Europe, and especially for more cross-border mergers, in a speech titled ‘Too much of a good thing? The need for consolidation in the European banking sector’.

Breaking down biases

Where cross-border bank M&A brings benefits to the ECB and the architecture of the EU, it could also build stronger banks by removing or reducing the national bias.

“A number of large banks in European countries may seek to do M&A to mitigate their geographic concentration, which in periods of instability tend to affect growth prospects, cost of funding and ultimately market valuation because of a higher perceived risk premium,” says Giorgio Cocini, co-head of EMEA financial institutions investment banking at Bank of America Merrill Lynch. 

In a contribution analysing mergers in the European banking sector for Bruegel, Patty Duijm, economist at De Nederlandsche Bank, and Dirk Schoenmaker, professor of banking and finance at Rotterdam School of Management, Erasmus University Rotterdam, make a similar point. For them, the key benefit of cross-border M&A is a diversification of credit risks, not of jurisdictions per se. According to their findings, “a bank active in two countries which expands its business into a third country experiences a reduction in default risk of close to 1.3%”, write Ms Duijm and Mr Schoenmaker.

Stronger European banks are also in the region’s economic interest: large corporates especially are calling for European banks they can rely on. This would reduce the risk of becoming too dependent on the big US banks, which might be less committed to the market if there was a crisis than a European lender.

“It is not only the efficiency gains or the capital gains, it is also achieving a banking system in Europe that can also be competitive on a global basis,” says Armando Rubio-Alvarez, co-head of financial institutions group for EMEA at Credit Suisse. “That is why I think the regulator is conceptually very supportive of bank consolidation. CEOs at larger institutions understand this but there are a number of clouds on the horizon that still need to be out of the way to be comfortable in achieving this pan-European wave of consolidation.”

Capital constraints

One such cloud is the capital requirements set by the Basel Committee and the capital buffers required for global systemically important banks (G-SIBs).

“If you merge two systemically important banks in Europe, there is a tangible likelihood for the combined group to move up into a higher bracket of G-SIB capital requirements,” says Mr Cocini, adding that while this would not necessarily result in the requirement of additional capital by the regulator, it would reduce the combined entity’s capital buffer versus minimum capital requirement.

“Although substantial synergies could be achieved from a large pan-European deal, the potential of moving into a higher G-SIB bracket is a negative item that could at least partially offset the benefits of a strategic combination from a value perspective in the eyes of the market,” he says.

Several investment bankers see this as a key issue restraining banks from attempting mega-mergers, and note that regulators and politicians are aware of the issue. Still, Scope’s Mr Theodore says he does not believe G-SIB capital requirements are a valid reason holding back M&A.

“Most large banks operate with levels of capital that exceed regulatory requirements, so there would be enough room for such transactions, even if you move into a higher bracket,” he says. “I don’t think G-SIB rules will be revised because they are the result of years of negotiations during and after the crisis. These rules are in place for a good reason.”

In her September speech, Ms Nouy hinted that some banking groups still have legacy assets, the true value of which can be difficult to assess – making it difficult to assess the ultimate economic value created by a merger.

More banking union…

But also the EU’s banking union, and where it is lacking, hinders large cross-border M&A. The free flow of capital from one jurisdiction to another, allowing international banking groups to borrow in one country and lend in another, has not been established, which means the European single market for banking services is lacking a substantial element of facilitation of business.

Lenders also have to comply with numerous national differences – aside from different business cultures and languages, something Ms Nouy has noted. “Tax codes and legal systems, for instance, differ between countries. And so does banking regulation – despite the single rulebook. These differences might also make cross-border mergers less appealing as they prevent banks from reaping the full benefits,” she says.

A lot hinges on building trust into the national regulators and systems in place in another European jurisdiction. Of course, there also is the common European Deposit Insurance Scheme (EDIS), which some see as a necessary next step. Others believe bail-in buffers need to be built first, NPLs need to reach acceptable levels and the doom-loop between sovereigns and banks need to be ended before EDIS can be added to the agenda.

…fewer national differences

Yet most observers believe that national regulators still have too much power in what is meant to be a banking union with a single supervisor. Bernd Ackermann, eurozone banking lead analyst at S&P Global Ratings, says: “The banking union is meant to be an integrated market but unlike domestic subsidiaries – which can have a waiver from the regulator for their subsidiary to comply with liquidity and capital requirements, based on the assumption that the parent would provide support – this is not possible on an EU-wide cross-border basis.” Banks have to comply with the regulatory requirements in each jurisdiction where a subsidiary is based. 

A way around this would be to have a branch, rather than a subsidiary, in an additional jurisdiction. It is something that Nordic regulators allow lenders such as Danske Bank and Nordea, but most eurozone countries still require foreign retail and commercial banks to maintain separate subsidiaries with independent capital and liquidity resources.

“National regulators prefer to see subsidiaries with local capital and liquidity on the ground rather than a branch, which would make it easier to shift capital adequacy around, because if there was a bank failure, they would be the ones having to answer questions from politicians about what they did to protect the provision of credit to the economy, avert a bank run and make sure depositors get compensated,” says Mr Ackermann. “They would have to rely on decisions taken elsewhere if local regulators were giving up some of their powers.” 

The ECB has a clear stance on this. In a letter to Enrique Calvet Chambon, a member of the European Parliament, ECB president Mario Draghi highlighted reasons for subdued M&A activity in Europe’s banking sector and used the opportunity to call for a further alignment of “regulatory treatment of domestic and cross-border banking groups… particularly as differences in such treatment no longer have a prudential justification, given the progress towards a complete banking union”.

The European Commission proposed to allow national regulators to waive local liquidity and capital requirements in the so-called ‘Trialogue discussions’ between the European Commission, the European Parliament and representatives of the EU member states in the form of the European Council. However, the member states did not support the proposal. Mr Ackermann notes that while the European Parliament appears to be more in favour of allowing a limited reduction of national requirements, “it shows that despite the potential benefits, there really is no broad-based support for a full cross-border waiver system for banks”, he says.

A domestic drive

The lack of political support to improve the operating and business environment for cross-border banking groups underlines a wider issue: that of political interference. Mr Theodore believes that even in areas where integration has been achieved (such as the bank recovery and
resolution directive), the national government would try to intervene in case a large bank of systemic importance was to be resolved. “The national government would seek to intervene and have a heavy say in the process,” he says.

While parts of the EU strive for further integration, especially the supranational bodies within the architecture, national politics does not always follow the same direction – the rise in populism representing the biggest spoilsport yet. A case in point is the election of a populist government in Italy, which will almost certainly delay any potential plans UniCredit and SocGen might have to merge.

The political uncertainty created by populists across the continent looks set to stifle further banking union integration in the near term – but more significantly, nationalistic agendas make political support for the takeover of a national champion by another EU member state’s bank even less achievable.  

What that leaves is domestic bank mergers – for example, the rumoured combinations of Commerzbank/Deutsche Bank and Barclays/Standard Chartered – although observers only see the potential Deutsche Bank combination as a likely near-term transaction, maybe even in 2018.

However, what there is likely to be more of is domestic consolidation among smaller banking groups in countries such as Italy, Spain, Germany, the UK and some of the Nordic countries, and a continuation of M&A within the challenger banking sector to create a larger rival to the big banks – as seen by the recent merger of CYBG (Clydesdale Yorkshire Banking Group) and Virgin Money in the UK. And maybe more domestic consolidation is actually needed to create some national economies of scale before any branching out abroad.

What, then, is the near-term future for pan-European bank M&A? A merger of Commerzbank and Deutsche could spark further mega-deals in the medium term, say some, but a rethink of G-SIB rules and certainty around the banking union and national regulatory requirements will be crucial for larger cross-border transactions.

Mr Rubio-Alvarez agrees that more certainty would be conducive and help de-risk investment theses, but both Mr Mesny and Mr Rubio-Alvarez believe “it is all about the business sense, the potential combinations that help grow the array of services and products, and providing better services to all clients being serviced. In the end, what makes sense for the running of the activities counts.”

There may yet be a surprise when it comes to large-scale M&A in Europe in the near future. 

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