Border Crossings

Financial institutions make up a quarter of global market capitalisation, a quarter of global M&A activity and a quarter of equity capital markets business, according to analysts. About 70% of debt capital market raisings are made by financial institutions.

In June 2005, the €16 billion takeover of German banking group HVB by Italian rival UniCredito - Europe's biggest cross-border commercial banking deal - raised the prospect of more big deals. It followed 2004's takeover of UK bank Abbey National by Banco Santander in Spain.

Vasco Moreno, who heads the European banks team at investment bank Keefe, Bruyette & Woods, says that there is definitely acceleration in banking M&A in Europe. He cites the fact that over the past eight years the top 30 European banking M&A deals included six cross-border transactions.

He says cross-border banking consolidation is being driven by high levels of excess capital in the sector of at least €35 billion, a fear of being left behind in the consolidation process and the need to achieve critical mass in some businesses.

He says there is also a search for growth and a need to deal with deficiencies in systems and technology.

NO SINGLE EUROPEAN BANKING MARKET

For all the rumours of bids and mergers between European retail banks, there has been disappointingly little progress towards the creation of a single, continent-wide market in financial services analogous with the single market in goods that the European Union has enjoyed for the past 13 years.

So far, most of the mooted cross-border banking tie-ups have faltered early on.

When seeking growth opportunities, Europe's big banks have tended to look either at home or further afield outside Europe. The lack of consolidation means that retail banks' costs continue to vary hugely from one European country to the next.

Were banks able to compete more freely across borders, many consumers might benefit from lower prices.

CULTURAL DIFFERENCES

Several reasons are given for the reluctance of European banks to engage in cross-border liaisons. Cultural differences are often mentioned first. At the same time, much is made of the local relationships and knowledge that drive a successful bank.

Undoubtedly there might be some difficulties for a bank moving into new territory, but these are surely overstated. For example, some 70% of the earnings of HSBC, Britain's biggest retail bank, come from abroad.

A far greater deterrent to Europe-wide integration is that the two arms of a merged bank would have to operate under different regulatory regimes while lacking a centralised payments mechanism.

Dealing with a jumble of rules means that any truly pan-European bank would find it hard to offer comparable products to customers in all the countries in which it operated.

IS AN INTEGRATED MARKET POSSIBLE?

Often, it is regulations, rather than the demands of customers for differing levels of service, that account for price variations.

Even if it were possible to offer homogeneous products across the continent, payments originating from a bank in another country could take many days to process. This would give domestic banks a competitive advantage over ones run from another European country.

The EU's leaders have been talking for years about what they can do to help banks overcome the obstacles and foster the creation of an integrated market in financial services.

The financial services action plan, launched in 1999, has made slow progress and is proving unpopular among the banks themselves.

They complain that the welter of new regulations proposed in the plan will in fact hamper progress and add to costs.

CROSS-BORDER RISKS

Economic nationalism of this sort, standing in the way of consolidation, is in evidence elsewhere in Europe. This reflects another factor holding back bank consolidation across borders: the fragmented nature of banking in countries such as Italy, Germany, Spain and France.

Here a simpler route to growth for ambitious banks is consolidation at home where big gains are still on offer. Rather than pay the higher prices needed to secure banks in other countries, banks prefer the rewards of domestic consolidation.

One of Europe's few truly cross-border banks, a Danish-Finnish-Norwegian- Swedish combination called Nordea is widely considered to have fared poorly.

FOLLOW THE LEADER

But Moreno nevertheless concedes that the UniCredito-HVB merger is a signal that consolidation activity could accelerate. The merger was considered a brave move, but one that catapulted UniCredito into the super league of European banks, and makes it the leader in terms of assets in Central and Eastern Europe.

"It is also not without risks, given HVB's large and historically troublesome balance sheet and the reduced capitalisation of the new entity," says Moreno, who sees the key to the deal's success as the aggressive synergy targets of €895 million from 2008.

"While we are heartened to see an emphasis on cost synergies, we give the group the benefit of the doubt that all this will be achieved in addition to the €280 million of cost cuts already announced by HVB in February."

Leonard Rabattu, head of the European banks team at SocGen, goes even further. He says the deal represents "a milestone in European banking. More than anything, we believe the key message, coming from the management, is that even in a country like Germany, cross-border deals may offer cost restructuring potential under certain conditions."

COST SAVINGS?

UniCredito is planning big savings from the deal with HVB, but a fair chunk of the €900 million cost savings promised from Alessandro Profumo, UniCredito's chief executive, will come from the two banks' Central and Eastern European networks.

Back office and IT are areas where banking mergers could provide savings. But will that be enough to persuade Europe's top banking executives and their shareholders that any deal will provide sufficient returns to justify the prices they will have to pay and the risks they will run?

Consider Santander's acquisition of Abbey in 2004. A well-devised strategic and economic rationale was proposed for what would become the fourth largest bank in Europe in terms of market capitalisation.

ABBEY ACQUISITION

Through its Latin American franchise, the Abbey deal would allow an optimisation of Santander's geographic exposure of capital and a reduction in the cost of capital, as the geographic distribution of capital becomes more skewed towards its European rather than Latin American operations.

Santander could transfer its superior IT systems to Abbey, and improve cross selling and expand in SME banking in the medium term. Santander's management team expects to generate €45 million of cost synergies over the next three years and €220 million of revenue synergies in three years.

Revenue synergy targets have been raised to €220 million, from a previous target of just €110 million. "This is an aggressive assumption indeed," says Moreno.

Despite the positives of an accelerated headcount reduction programme which should improve cost savings in the first year, 'Revenues may be more challenging at the moment despite management assurance that in the medium term the potential is higher,' Moreno says.

The key area of focus at the moment is the stabilisation of market share in mortgages. The price paid by Santander makes it challenging for the deal to be value-creative in the short term. "In the medium term, we believe this is at best a value-neutral deal," says Moreno.

LIKELY M&A CANDIDATES

But where are the deals going to come from? For Leonard Rubattu, the two banks most likely to embark on a major transaction are Commerzbank and Erste bank.

"The convincing presentation given by UniCredito on their offer for HVB is likely to have changed some investors' minds on what can be achieved in Germany from a cost-rationalisation point of view," he reasons.

For Moreno, Commerzbank is also the most likely merger party, along with ABN Amro. He says management at Intesa, San Paolo IMI, Nordea, BNP, SocGen, Credit Agricole, KBC, Dexia, SEB, Barclays, RBS, HSBC, Santander and BBVA must also be weighing up their options.

"These banks must, however, proceed with care as most transformational cross-border merger attempts end in failure," he says. "The economies of these deals are important, management conflicts greater, cultural gaps more visible, shareholders more cynical about merger value added and regulatory scrutiny are intense."

MEDIUM-SIZE TARGETS

Evangelos Kavouriadis, an analyst at Bernstein Research, says the market assigns too high a probability to the very small banks in Italy, Germany, Greece and Spain becoming acquisition targets.

Instead, he argues that attention should be directed toward the medium-size banks in France and Benelux – those just below the national champions in size, but with market caps above €20 billion, such as ABN Amro, Fortis, KBC, Dexia and SocGen.

"These are averagely priced, averaging a 155 P/E discount to their European peers," he says. "BNP, Royal Bank of Scotland and Lloyds are amongst their potential acquirers."

According to Kavouriadis, there are three other reasons making the banks in Benelux, France and Scandinavia ripe for further M&A.

"First, those areas have already started to create super-regional European banks. Second, there are enough second-tier targets in those regions to satisfy the M&A demand we expect. Third, European banks are likely to follow the roadmap successfully undertaken by US banks in their consolidation process to form super-regionals, as they gradually moved from in-market deals to deals in adjacent areas."

CONTINUING SCEPTICISM

Despite the furore, the wheels are starting to fall off the European banking M&A juggernaut.

Last August, Royal Bank of Scotland chief executive Sir Fred Goodwin declared that cross-border mega-deals in Europe's banking sector were just around the corner. Sir Fred's comments naturally left the market wondering who on earth he was planning to buy.

To make matters worse, he put his thoughts down on paper too, leaving a question mark beside the phrase 'European acquisitions' in the interim results presentation and strategy plan he passed around the City.

Ever since, rumours of a tie-up between RBS and Dutch bank ABN Amro have been flying around even more frequently than before - much to Sir Fred's irritation. But nothing has happened yet. If anything, RBS looks closer to doing a major deal in China than Europe.

Barclays' chief executive John Varley says he will not be pushed into doing deals in order to satisfy shareholder demand for growth. "We won't be dependent on mergers to drive the growth of the bank," he explains.

Last Spring ABN Amro said it would offer €6.3 billion in cash for Banca Antonveneta, Italy's number nine lender, in which it already has a stake.

ABN took de facto control of the bank after an extraordinary general meeting of Antonveneta's shareholders elected a 15-member board composed of ABN Amro candidates to take control of the bank.

Antonio Fazio, governor of the central bank, faced mounting calls for his resignation after he was accused of attempting to block the Dutch takeover of the bank in favour of a local rival's bid.

With this degree of scepticism it seems the drive for European banking mergers still has some way to go.