Bank Eat Bank

Europe's once invincible giants are proving highly vulnerable in no-holds-barred warfare

The $80 billion merger of Union Bank of Switzerland and Swiss Bank Corp. was consummated this summer. But the marriage had its tensions along the way. The day of the engagement party last December, Union Bank CEO Mathis Cabiallavetta badly cut his chin shaving. Chairman Robert Studer forgot to wear a belt. Swiss Bank CEO Marcel Ospel, on the other hand, looked like the cat who swallowed the canary. Little wonder. His bank, Switzerland's No.3, was consuming the country's much larger No.1 bank. Ospel got the CEO post, and his lieutenants took most of the other key jobs at the merged bank, now called simply UBS.

The deal was a watershed, and not just because it created Europe's biggest bank, with $754 billion in assets. It shows how quickly once seemingly invincible European banking giants can become vulnerable if they make a financial misstep. Union Bank ended up being merged into its smaller rival partly because $443 million in derivatives trading losses in Asia last year put it under pressure from Swiss investor Martin Ebner. Now, with the crises in Asia and Russia intensifying, other European lenders could become ensnared in similar binds just as they are facing massive competitive pressures from Europe's move to a single currency as of Jan. 1. "The major challenge for the European banks is to position themselves for EMU. The emerging-market crisis has only added to the risks," says London-based Salomon Smith Barney analyst Matthew Czepliewicz.

With European Monetary Union looming, big banks such as Germany's Deutsche Bank, which was relegated to Europe's No.2 by the UBS merger, have known for months that they, too, must come up with daring consolidation plans or risk losing power. But the ante has risen as they've hesitated. Plunging stock markets and financial crises overseas underscore the perils of the European banks' strategy: globalization through huge new investments in investment banking, asset management, and other securities-based businesses.

Crashing markets have slashed the price of potential targets. Most financial stocks in Europe and the U.S. are off one-third from their 1998 peaks. Profits at most banks will also take a beating. But lenders still must move forward on the massive mergers that have been in the works for months. "It's like a kettle coming to boil," says Leonhard Fischer, a board member at Dresdner Bank, Germany's No.3. "You don't know when it's going to happen. You only know the pressure is building, and sooner or later it's going to blow."

A merger boom in European banking seems inevitable as EMU melds 11 different financial markets into a single, $6.3 trillion economy. Banks in Germany and France, some of the world's biggest, may come into play. But giants in nations such as Switzerland and Britain, which are outside the union but still within its sphere of influence, are just as worried. As companies and investors begin to move money around Europe more freely, banks will have to expand beyond national borders to keep pace. The euro "is going to change European banking profoundly," says Robert de Metz, a board member of Paribas, the Paris-based investment bank. In a decade, perhaps only a dozen mammoth institutions will remain, including insurers such as Germany's Allianz, Switzerland's Zurich, and France's AXA-UAP.

Now, the financial meltdown abroad is intensifying the pressure. On top of heavy provisions last year for losses in Asia, many European banks may take big hits in Russia and other emerging markets. Conventional bank loans aren't necessarily the problem. For instance, even though at yearend Germany had $30 billion in loans outstanding to Russia and France had $7 billion, most of the credits are government-backed. Analysts figure Germany's four big private banks--Deutsche, HypoVereinsbank, Dresdner, and Commerzbank--have a net exposure of about $2 billion, 60% of which is already written down.

But bond and other trading losses could dramatically increase the pain. Britain's Barclays Bank says it lost $418 million in emerging markets in the first half of this year. And analysts figure Credit Suisse, the top trader in Russian government bonds, lost up to $700 million there in August. Credit Suisse says its net exposure in troubled emerging markets is $8.2 billion, 26% of which is in Russia. Credit Suisse First Boston's CEO, Allen Wheat, says the situation is an "extraordinary event" that will have "absolutely no impact on our strategy."

Still, losses may multiply if the crisis spreads. Morgan Stanley Dean Witter & Co. estimates the euro zone's holdings of loans from Eastern and Central Europe at $84 billion and from Latin America at $133 billion, about the same as in non-Japanese Asia. Most of the debt is owed to governments or government-backed bodies. But contagion fears explain why shares of Banco Santander and other Spanish banks with heavy Latin American exposure have also fallen despite lofty profits.

If Europe's market slide turns into a rout, count on more damage, since many of the big banks have had an earnings boost from booming markets. Bank analysts at CSFB figure that trading, securities, and asset-management fees now account for 30% of the big German banks' operating profits, up from 20% in 1994. At Deutsche Bank, volatile trading income accounts for 15% of operating income, CSFB figures.

Amid the turmoil, bargain hunting may break out. Britain's highly profitable Lloyds TSB Group PLC was out sniffing even before the crash. ING and ABN Amro are both interested in making major acquisitions, likely in France, while Deutsche and Dresdner are scouting the U.S. Persistent rumors link J.P. Morgan in a deal with Deutsche Bank or another European. PaineWebber Inc., according to recent whispers, may be the target of a joint bid by Dresdner and Allianz. UBS and Credit Suisse Group also are rumored to be on the prowl. However, cautions Credit Suisse Group CEO Lukas Muhlemann, "if we do a megamerger, the other party will have to add value, not just size. That kind of partner is not easy to find."

But the market clearly likes the prospects of some potential acquirers better than others. Shares of UBS are still up 13%, ABN Amro up 7%, and Credit Suisse is down 6% since Jan. 1. The Germans, on the other hand, seem vulnerable. Deutsche Bank shares were already lagging when the crisis hit, but fell by 30% from their peak anyway. They're now trading at only 1.1 times the bank's net asset value--versus 2.3 times for European banks on average, figures J.P. Morgan.

Investors are skeptical of many old-line banks because monetary union is wrenching them into a cutthroat era. Since World War II, gigantic universal banks like Deutsche have dominated Continental banking. Unhampered by laws such as the Glass-Steagall Act that separates U.S. commercial and investment banking, Europe's banks could handle any financial transaction, from making personal loans to trading stocks and selling insurance. Their forte was "relationship banking," based on personal ties and cross-shareholdings with key corporate customers.

That cozy system stifled competition and stymied innovation. Since a few big banks in each nation had a hammerlock on corporate finance, Europe's equity and corporate-debt markets remained immature. Meanwhile, U.S. banks moved far ahead with sophisticated products and technique, and U.S. financial markets offered a much deeper pool of capital. Now, as the financial needs of European companies grow, Continental banks are scrambling to catch up. The loyalty of corporate clients that formerly used just one "house bank" has been severely eroded by price competition. And the breakdown of the banks' cartel-like pricing of financial products is squeezing profits.

DOUBLE TROUBLE. As a result, European bank profits were threatened even before the world's current financial troubles. Europewide revenues from corporate lending, already a low-margin business, will be cut nearly in half, to $50 billion, in a few years, as ever smaller companies demand price breaks, predicts McKinsey & Co. Once the euro arrives, other profit sources will suffer. McKinsey estimates that about 70% of the typical European bank's foreign exchange business will disappear. Such trading, accounting for 5% of the typical bank's earnings, is already "dead, dead, dead," in anticipation of EMU, says John Leonard, a London-based Salomon Smith Barney analyst. Meanwhile, the fiscal austerity mandated under monetary union means that even government bond issuance will shrink as nations borrow less.

More troubling is the impact a prolonged bear market would have on the explosive growth of higher-margin mutual funds and asset management services. Even if markets bounce back, Europe's high money-management fees--about double the U.S. level--will be reduced by heightened competition, predicts Paribas' de Metz. Indeed, many of the several dozen investment banks the Europeans bought or launched in the last decade are floundering. The British have all largely dropped out in the past year. Continental rivals know survival means doubling their already huge bets on the business. "We have to expand, become pan-European, and define a U.S. strategy or be limited to a niche position," admits Dresdner's Fischer.

So experts think banks will have no choice but to specialize in businesses where they can compete across Europe. A Lazard Freres or Paribas may duke it out with America's Goldman Sachs and Morgan Stanley in investment banking. Germany's HypoVereinsbank wants to become the Continent's specialist in mortgages, while some rivals may focus on lending to service industries. "In a highly fragmented and overbanked market, it is important to show a clear profile--what your strengths are and in which fields you are better than your competitors," says Albrecht Schmidt, HypoVereinsbank 's CEO.

Cost-cutting also is important, which is why more big domestic mergers are likely in over-banked nations like Germany, France, and Italy. "Consolidation has to move ahead within domestic markets all over Europe," says Alessandro Profumo, managing director of Milan-based Credito Italiano. "That's where the major cost savings are." Union and political opposition mean staff cuts and branch closures take longer on the Continent than in the U.S. But there are still major savings--typically 15% to 20% over several years, Salomon Smith Barney figures--from merging computer systems and eliminating overlap. J.P. Morgan Co. estimates that $102 billion in value could be created by restructuring major banks--60% of it from mergers, most of the rest from securitizing low-performing loans.

TAX TRAP. At this point, Germany's giant Grossbanken seem among the most vulnerable. Both Deutsche and Dresdner have massive industrial holdings on their balance sheets--$24 billion and $15 billion worth, respectively, J.P. Morgan estimates--that could fund acquisitions. But under current German law, any sale would trigger capital-gains taxes of more than 50%. Moreover, Deutsche Bank CEO Rolf-E. Breuer doubts that tax reforms after the Sept. 27 election will change the law enough to make such sales attractive. "I'm afraid that's true no matter which side wins," he says.

Germany's giant lenders have also been plagued by internal strife, and management heads are rolling as never before. At Dresdner Bank, CEO Jurgen Sarrazin was forced out in 1997 when he was unable to squelch a tax scandal or enunciate the bank's strategy. Although Deutsche Bank denies it, Frankfurt banking sources believe that board member Renaldo H. Schmitz will be forced into early retirement as penance for his role in the investment banking debacle, a hole into which analysts figure the bank has poured at least $3 billion over the last decade.

Indeed, the infighting at Deutsche has rivals thinking it could accomplish a large merger only if it agreed to the subordinate management position. Until recently, Germany's No.1 bank seemed the only European likely to challenge U.S. rivals head-on in every financial field. But the merger and acquisitions arm of its investment bank imploded after a reorganization announced earlier this year. Now, its credibility is so tarnished that the Americans are looking over their shoulders at Switzerland's UBS instead. The latest in a string of staff defections came in July when Frank Quattrone, the California-based star of high-tech M&A whom Deutsche had lured away from Morgan Stanley with a big pay package, bolted to rival CSFB with 130 bankers.

It's uncertain that size will determine the winners in the coming shakeout. Besides, politicians may intervene if the banks get hit too hard by dog-eat-dog capitalism. Some analysts estimate that the European banking business may shrink by 200,000 to 500,000 jobs within a few years--one reason the taboo against unfriendly takeovers remains strong. While this may slow the banking transformation, the momentum is too strong to restrain it for long. "Five years from now, being a banker in Europe is going to be a much tougher job," says Andreas Dombret, a banking expert in J.P. Morgan's Frankfurt office. It's already getting more perilous. Just ask the execs at UBS.

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