Unhappy Returns at Europe's Banks

They're taking a beating. Is a wave of mergers next?

They rank among the worst two days in European bankers' memory. Bank stock prices across the region had already fallen off a cliff since July (chart). Then, in early October, rumors starting flying that Germany's Commerzbank had taken big losses on derivatives bets and could face liquidity problems. On Oct. 7-8, the market punished not just Commerzbank, which dropped 12.5%, but the entire sector. Switzerland's Credit Suisse Group fell 16% in the two days, the Netherlands' ABN Amro 11%.

European banks, once the rock-solid, state-backed foundation of the region's economy, are in dire straits. Bad loans are surging, profits are slumping, credit ratings are being downgraded, investors are panicking. The market capitalization of the Continent's 50 largest lenders has fallen by half since the beginning of this year, leaving many once-mighty institutions vulnerable to hostile takeover bids. According to seasoned financiers, the turmoil could spur a new round of restructuring, including domestic mergers and, for the first time, major cross-border combinations. Commerzbank is among the possible prey; analysts have it being snapped up by France's BNP Paribas or Britain's HSBC Holdings PLC (HBC ). Deals on that scale would hasten the creation of a much-needed single European market for financial services.

It's easy to see why investors are scared. European banks are sacking staff by the thousands and taking a scalpel to costs, yet revenues are falling faster than expenses. In a sluggish economy, there is little demand for lucrative commercial or investment banking products, so banks are earning far less than they expected this year. To make things worse, meager growth is squeezing corporate profits and spawning a record number of bankruptcies among borrowers. That, in turn, has forced many lenders to pile up their loan-loss provisions, often by 50% or more. Around 1.1% of all European bank loans are expected to go sour this year, compared with just 0.6% last year. "The banks are being squeezed by powerful forces on a number of fronts," says Chris Gentle, European director of Deloitte Consulting in London. "There's a real fear factor. Bankers are wondering what's going to go wrong next."

Given all that, it's hardly surprising that banks have been lining up to issue profit warnings and disclose falling capital ratios. Fortis, the Belgo-Dutch banking and insurance powerhouse, on Oct. 2 said its core capital had fallen from $19 billion to $16 billion in the third quarter. Analysts in Frankfurt expect that Deutsche Bank, which under new CEO Josef Ackermann has led the field in cost-cutting and restructuring, will soon be forced to abandon its earnings prediction for 2002.

Although regulators insist there is no cause for alarm, many in the industry are not so sure. Their already-frayed nerves were given a serious jolt on Oct. 4, when a Merrill Lynch & Co. executive asked credit-rater Standard & Poor's to comment on rumors that Commerzbank had "sustained large trading losses in credit derivatives" and was having serious liquidity problems. Commerzbank officials denied the rumor. CEO Klaus-Peter Müller told staff in an internal memo that "there are no grounds for questioning the solidity of our bank." But the damage was done.

In this nervous environment, Douglas Flint, finance director of Britain's HSBC, one of Europe's strongest banks, added fuel to the fire by expressing concern about the "systemic implications" of the large losses that some other banks have run up. Shares in Commerz and Credit Suisse quickly plunged to their lowest level in more than 10 years. Plenty of stronger banks, such as ABN Amro and France's Société Générale, also took a hammering. "Investors used to think of us as a safe haven," says a managing board member of one large German bank. "Now, some seem to be worried that we aren't going to survive."

Despite this perfect storm, most analysts doubt there is any real threat of a major bank going bust. But the experts do predict that the current bout of jitters will force banks to rethink their strategies, reshape their structures, and embark on another round of cost-cutting. Management is already swinging the ax. On Oct. 7, Commerzbank CEO Müller unveiled plans to make "hundreds" of job cuts. That's on top of the 4,300 he has already said he will scrap by the end of next year. John J. Mack, one of Credit Suisse's two new co-CEOs, says he will let 1,750 more employees go at Credit Suisse First Boston, the group's investment bank, in the face of falling revenues. He has already fired 4,800 workers--16% of the total--over the past year. And it's not just the rank and file that are losing their heads. Abbey National PLC CEO Ian Harley was unceremoniously fired recently. And in the face of intense shareholder pressure, Lukas Muhlemann has announced that he will quit as chairman of Credit Suisse Group in December.

At the same time, many banks will be forced to focus more on their core businesses. "They'll sell off some operations, streamline others, buy others, and concentrate their capital where it can be used most productively," predicts Gentle of Deloitte Consulting. The process has already started. Deutsche Bank is hiving off its securities-processing business. And given all of its problems, "Credit Suisse will have to think very seriously about selling either [its] Winterthur [insurance arm] or CSFB or both," says a former managing board member.

But cutting more staff and divesting some subsidiaries still may not be enough. Some financiers predict that one result of the current turmoil could be a wave of mergers that could transform the structure of European finance and lead to the creation of truly pan-European banks. Abbey National has already put itself on the block. Although two rounds of discussions--one with Bank of Ireland--have so far come to nothing, there are plenty of potential acquirers, including National Australia Bank, waiting in the wings. Analysts are even speculating about a move on Credit Suisse by archcompetitor UBS. Credit Suisse and UBS once had dueling market capitalizations: Now, UBS's stock value dwarfs that of Credit Suisse. Both banks deny any merger is afoot.

Given the banks' grave problems, the obstacles to cross-border mergers, most of them erected by governments, could soon start falling. On Oct. 8, European finance ministers took one step in that direction when they unveiled plans to create four new groups that will write pan-European rules for the financial system. Although it was only by chance the meeting coincided with the debacle of Oct. 7-8, the timing could not have been better: The banks' crisis is now Europe's as well.

By David Fairlamb in Frankfurt, with Stanley Reed in London and Carol Matlack in Paris

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