By James Davis
This article first appeared on Financial News on April 11, 2020.
The financial crisis of a decade ago had a chilling effect on bank mergers across Europe. Policymakers expressed legitimate concerns about banks being too big to fail and raised questions about prudential authority and the political implications of using taxpayer money to keep firms solvent during a crisis.
Now, the pendulum has swung the other way, and European wholesale banks are finding that instead of being too big to fail, they might be too small to thrive.
Stymied for years by slow growth, low profit margins and loss of market share to big foreign rivals, many of Europe's most important wholesale banks have limped along as rivals gained strength. From that position of weakness, they are now heading into an economic slowdown of historic magnitude.
Without consolidation, the industry is likely to remain only marginally profitable at best for the foreseeable future. That will make it more difficult for them to raise capital for their clients in future crises
Without consolidation, the industry is likely to remain only marginally profitable at best for the foreseeable future. That will make it more difficult for them to raise capital for their clients in future crises. At worst, it could be a future in which big European banks pull back from businesses one by one, ceding those markets to foreign rivals and leaving Europe without a single national player that can be relied on to carry out policy objectives and deploy capital at times of severe economic stress like the one faced today.
Consolidation isn't a new concept. Before the financial crisis, mergers among wholesale banks were commonplace. From 1995 to 2009, there were 20 deals per year among wholesale banks in Europe, the Middle East and Africa. That number has shrivelled to just seven per year over the past decade.
Policymakers of late have signalled willingness to entertain the idea. Andrea Enria, the head of the European Central Bank's Single Supervisory Mechanism, said in January that "There is no supervisory impediment…that we want to throw into the way of consolidation". José Manuel Campa, chairman of the European Banking Authority, said in December he supported consolidation "if it results in a greater financial institution".
That's largely because European wholesale banks simply aren't profitable enough when compared with their peers. They entered the current crisis with a return on equity of about 6%, compared with the overall industry average of roughly 9%. Many European wholesale banks today trade at half their book value.
As European banks have struggled, US banks have come to dominate European capital markets. EU banks now control only 26% of capital market revenues in Emea. That means large European companies are increasingly dependent on foreign banks for access to capital markets and funding. It also means there is a high dependency on US banks for markets core to the functioning of the financial system. For instance, in government bonds and repo, European players, broadly defined, account for only 53% of the market. There is debate amongst policymakers and industry leaders over whether this should be a matter of concern.
Not only are European banks smaller than US banks — they also have higher costs. The top seven European banks on average have $3.8bn of capital driving revenue for every $1bn of fixed cost base, compared with $5.1bn for the top five US players.
Past experience points to the potential for consolidation to help firms cost cuts. The absorption of Bear Stearns, Lehman Brothers and Merrill Lynch into other players over 2008-09 helped drive $15bn to $20bn of cost out of the industry, equivalent to 50% to 70% of the cost base of the acquired companies.
Consolidation also could help create meaningful scale for midsized European globals. These banks typically generate only around 50% of their revenue in products and regions where they are in the top five. By contrast, US banks generate 90% of their revenues in businesses where they are in the top five.
Even after accounting for some revenue decline following a merger, most combinations of two large European players would in theory have 70% of revenue in the top five for the product per region. As well as improving profitability and operating leverage, there would also be capital and funding synergies.
To be sure, there are many complexities to executing such a transaction, not least of which is establishing the home market. The European market is fragmented and, beyond differences in language and domestic market conventions, relevant laws vary across European jurisdictions. This is particularly true for laws indirectly affecting banking products — such as bankruptcy and consumer protection. Merging two entities at the wholesale level would require not only the commercial rationale but also the alignment of regulators and other stakeholders.
Assuming these hurdles can be overcome, what might success look like?
In two years' time, there could be one or two strong European players ranking among the top five alongside the US giants. At the same time, some cross-border combinations would appear at the middle level, strengthening relationships across the entire European economy. And the entire European wholesale banking industry, so beleaguered heading into the current crisis, would emerge stronger, more resilient and better able to help their customers heading into the next one.