By Richard Barnes, Senior Director, S&P Global Ratings
Mergers and acquisitions (M&As) are back on the agenda as a possible solution to European banks’ profitability woes. Policymakers have also spoken in favor of consolidation to establish regional champions and accelerate the eurozone banking union.
We think the regulatory and market environment does not yet support large deals, particularly cross-border ones. Instead, we expect that transactions will remain limited in number and focused on in-market transactions between midsized institutions.We see compelling logic for large-scale, cross-border consolidation in the longer term if the current barriers are broken down.
Squeezed earnings
Profitability varies significantly across Europe. Dominated by Nordic banks, the best performers cover their cost of equity and make material payouts to shareholders. However, the majority of banks struggle with margin compression, structural inefficiency and industry overcapacity. The economy is unlikely to provide a helping hand due to slowing growth and persistent ultra-low interest rates.
M&A is not a panacea, but well-executed consolidation has the potential to support pricing power and efficiency. It could also enable banks to spread their growing digital-investment and regulatory-compliance costs across a larger revenue base.
Ripe for consolidation?
Much of Europe is overbanked, and there is plenty of scope for consolidation without raising competition issues. Retail and commercial banking sectors are heavily segmented nationally, with only a handful of firms having a material presence in more than one country. In fact, banks generally retreated to their domestic markets following the global financial crisis as they prioritized balance-sheet strength.
Despite banks’ earnings woes, mergers and acquisitions have been sporadic since the financial crisis. A notable exception is Spain, where there has been an orchestrated domestic consolidation process.
In pursuit of regional champions
Eurozone policymakers appear attracted to cross-border M&A as a means to cement the banking union and ensure more effective transmission of monetary policy. During the eurozone debt crisis, the banking sector’s overwhelming national focus created a negative feedback loop between sovereign and bank creditworthiness. By diversifying risk, the creation of cross-border groups could promote economic integration, stabilize credit availability and pricing in future recessions, and reduce the risk of deposit flight from stressed systems. However, there is a catch-22 here. Policymakers advocate cross-border mergers to strengthen the banking union, but banks need to see tangible progress toward a stronger banking union before they can justify transactions to their stakeholders.
M&A could also enable European banks to reclaim a stronger footing on the global stage. Their diminished valuations and scale mean that few rank today among the world’s largest banks by market capitalization. This does not appear to concern banks’ management and investors, which are more focused on near-term priorities, particularly strengthening shareholder returns. In contrast, policymakers may worry about greater reliance on foreign competitors in segments such as investment banking, and those firms may be less committed to the region in the next downturn.
Cross-border merger speculation feels premature.
We see the incomplete banking union as one of the obstacles that make cross-border European consolidation unlikely for the moment. The eurozone remains far from a seamless, harmonized banking jurisdiction. Most countries require local subsidiaries with independent capital and liquidity resources. If they persist, these inefficiencies will reduce the potential benefits of cross-border mergers. Before embarking on material transactions, banks may also prefer to wait until the European Union (EU) decides how to implement the final Basel III reforms.
Large-scale M&A would produce more complex and interconnected banks that could potentially amplify systemic risks in future financial crises. Resolution authorities’ too-big-to-fail concerns are unlikely to ease significantly, at least not until major banks take further steps to become truly resolvable. For globally systemic banks, increased scale arising from M&A might well lead to a higher systemic-risk capital buffer that could call into question the business case for a transaction.
In the current climate, banks are likely to be cautious about litigation and conduct risks attached to acquisitions. These typically take several years to emerge, and due diligence may not quantify or even identify them. We note that Santander is among the subjects of legal action related to resolution actions taken at Banco Popular prior to its acquisition last year. Certain jurisdictions and business models carry relatively elevated litigation and conduct risks, which could weigh on M&A in those segments.
In addition to regulatory barriers, differences in European countries’ legal and bankruptcy codes, tax regimes, products, culture and language, and customer habits can reduce the benefits of cross-border consolidation. Even neighboring countries can have dramatically different operating models in retail and commercial banking. The economic rationale for M&A typically hinges on rationalizing technology, operations and distribution networks. In cross-border deals, despite potential savings in areas such as branding and procurement, there is less scope for meaningful cost synergies to justify a merger premium.
Operational challenges
Large-scale mergers are inherently complex, and a successful outcome is less likely if one or both partners begin in a state of operational flux. We, therefore, see the logic in prioritizing internal restructuring and technology enhancements before looking for inorganic growth opportunities. This was a factor behind the termination of merger talks between Commerzbank and Deutsche Bank. Equally, shareholders appear to favor dividend growth over consolidation, but their stance could perhaps change if they perceive greater M&A benefits or lose faith in banks’ prospects as stand-alone entities.
Domestic deals could lead a moderate M&A pickup.
After weighing up the catalysts and inhibitors, we see scope for increased European bank consolidation. However, we do not anticipate a surge in deal-making or a significant number of cross-border or large-scale transactions. Domestic M&A has dominated recent activity, and we expect that pattern to continue. In-market deals are an easier sell to shareholders and regulators because of greater synergies and lower execution risks.
An M&A sweet spot could be midsized banks combining to strengthen their ability to compete with the market leaders. We may also see large banks acquiring smaller peers, provided these deals are worth the effort to the buyer, which would be the case if they offer something that it could not achieve organically in a reasonable timeframe. Acquisitions of subsidiaries and portfolios enable buyers to increase scale in a particular segment without taking over an entire group. This strategy appears most relevant in sectors including developing markets, private banking and asset management.
In addition, we anticipate that banks will increasingly explore alternatives to M&A that realize some of the benefits with lower risks. For example, banks might be wary of acquiring large branch networks that have reducing value in a digitalized world. They could instead pursue economies of scale by combining back-office functions, assuming legal, compliance and data-protection issues can be adequately addressed. Banks can alternatively emulate fintechs through cross-border expansion in directly distributed products, such as deposits, payments and consumer finance.
While consolidation is not front of mind right now for most managers and shareholders of European banks, times may change. In the longer term, executing targeted business and operating-model transformations may provide greater support to their struggling share prices, which would increase their ammunition for future M&As. Once cross-border mergers eventually begin, they could quickly snowball if shareholders are supportive and banks rush to get involved for fear of missing out.
M&A is typically ratings-neutral at best for the acquirer.
European banking M&A has a patchy track record from both a shareholder and a creditor perspective. Positively, consolidation can help banks to develop their franchises, diversify their risk profiles and strengthen capital generation through earnings. However, realizing M&A benefits has inherent execution risks, and deals can also dilute capital ratios, depending on the chosen financing structure.
For an acquirer or the dominant participant in a merger, transactions are usually ratings-neutral at best when first completed. However, deals can weaken creditworthiness if we conclude that they materially weaken the buyer’s business stability or capital ratios. We typically see less risk in domestic deals than cross-border ones because we generally have more confidence in integration synergies, cultural fit and the ability to manage regulatory and legal issues. M&A can support positive rating actions in the years following completion of a deal if it is well executed and works to the benefit of creditors.