Europe's Border-Hopping Banks
By Bernard de Longevialle and Peter Dutton
European banks are reaching across national borders to buy other banks at a stepped-up pace in 2005 -- one that may break last year's record. Although the consolidation process seems to be gaining in size and momentum, boosted by industry trends and bank-specific situations, Standard & Poor's Ratings Services doesn't expect it to accelerate further beyond this year.
Considering their high execution risks, uncertain risk-reward profiles, and the reduced number of banks ready to give up control, the completion of more than a handful of major cross-border transactions by yearend 2007 appears unlikely. As recent large cross-border deals have tended to involve a relatively weak target, the reduced number of available underperformers should forestall a jump in the number of deals and suggests that the next cross-border operation could be a real merger of equals involving two strong performers.
In the currently benign credit environment, where most ratings on European banks carry stable outlooks, cross-border deals could be among the main drivers of rating volatility in the coming two years. The execution risks, changes in risk profiles, and higher leverage that M&As entail could lead to immediate downgrades for acquirers.
RISKS AND COSTS.
In contrast, lower-rated targets could see immediate upgrades, and therefore be the main beneficiaries of M&A activity in Europe. In the long run, the overall rating impact of bank consolidation in Europe should be positive on average, however, thanks to the creation of more diversified and better-managed banking groups.
With the anticipated end of the mortgage boom as well as the likely turn in the credit cycle in coming years, many European banks will likely face difficulty delivering strong organic growth in their already highly leveraged domestic markets. To achieve their double-digit public targets for growth in earnings per share (EPS), European banks may turn to alternatives -- including share buybacks or M&As. In fact, in the drive to deliver strong and sustainable EPS growth, the relative value of European cross-border M&As has been increasing.
These alternatives aren't avenues to growth for every bank in Europe, however. The already high level of concentration and restrictive shareholder structures should prevent further significant in-market moves in most European markets, at least in the short term. As for targets in the rest of the world, possibilities might appear unlimited, in theory, but in reality the number of immediate, sizable, and revenue-enhancing opportunities is small or may carry large risks or price tags, for example:
• In large Central European or Latin American markets, most available targets already have been scrutinized.
• Other potentially promising markets in Asia are still closed to foreign takeovers, and are not a key focus area for most European banks.
• Other large markets such as Russia are still considered high risk.
• In developed markets outside Europe, such as the U.S., targets are numerous, but valuations are increasingly high. Geographical distance and cultural differences remain barriers that only a few European banks can surmount.
Given that most banking markets in Europe benefit from sound operating environments in rich and diversified economies -- and since the banking systems overall are profitable and low risk -- the region's banks can be attractive targets. The ongoing creation of a single European market, generating ever-increasing needs for cross-border financial services and greater potential for synergy, provides a growing competitive advantage to border-breaking deals. As European authorities push for the creation of a true pan-European banking market, regulatory barriers are likely to erode and nationalistic attitudes to recede.
In certain business lines, cross-border deals already promise synergies as large as for in-market arrangements. This is notably the case in wholesale banking, where size, coverage, and volumes are becoming key factors for a successful business model. Significant synergies can also be achieved in institutional activities such as asset management, payment, custody, and consumer finance, where data-processing costs weigh heavily on the bottom line. Several banks pursuing pan-European development strategies in these areas might be tempted by takeovers, should good opportunities present themselves.
Within retail banking, achieving synergies is clearly less of a pretext for a cross-border deal than for an in-market move, mainly because of the absence of network overlaps. Many European banks' profiles remain dominated by labor-intensive, branch-based, country-specific networks that limit the potential for synergistic cost cutting. There's some room for synergies, however, in procurement centralization and the groupwide sharing of best practices in IT, for example, since both of these functions are becoming increasingly important to both commercial development and cost containment.
MORE TO COME.
After Spain's Banco Santander Central Hispano (Santander; A+) acquired Britain's Abbey National (A+) in 2004, the acquirer decided to cut costs. Santander's ambitious, yet credible, target for more than a 15% reduction in Abbey's operating cost base by yearend 2006 exemplifies the kind of potential that best-practice banks could seek in retail cross-border transactions.
The stock market's very positive reaction to the earnings potential inherent in recent and announced deals, such as those by Santander for Abbey and Italy's Unicredito Italiano (AA-) for Germany's Bayerische Hypo- und Vereinsbank AG (A-), should also encourage other European banks to follow suit. Stock markets seem ready to buy good stories, despite the material execution risk that cross-border deals entail.
De Longevialle and Dutton are credit analysts for Standard & Poor's Ratings Services