TSB sale: Nobody expected the Spanish acquisition

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Banco Sabadell might find the capital costs of its TSB merger experiment tougher than initially anticipated if the European Commission turns against deferred tax assets.

TSB-R-600

Europe’s banking sector is in desperate need of consolidation, something that its new single supervisor is acutely aware of. Given the limited potential for ROE growth among the region’s banks, it seems puzzling that more merger activity has not happened.

There is, therefore, intense focus on those mergers that do happen, as they could be potential blueprints for any future M&A wave. 

Sabadell’s purchase of TSB may or may not end up as a poster child for future business. Faced with intense margin pressure at home, Banco Sabadell’s decision to follow Banco Santander to the UK took many by surprise, but is understandable: its UK operations are Santander’s most profitable division. 

This is an awful deal
Banking analyst

However, critics claim that in following Santander and buying TSB, Sabadell is taking on a business its doesn't sufficiently understand in a market where it has no experience. 

"This is an awful deal," sighs one UK-based banking analyst.

Lloyds is required to dispose of its interest in TSB by the end of 2015 as a condition of its bailout during the financial crisis and many feel the UK bank has accepted the Sabadell offer with unseemly haste, having already been burned by the fiasco of the collapsed Project Verde sale to the Co-operative Bank in early 2013. 

That deal fell apart as the Co-operative Bank’s own life-threatening problems – bad lending, IT failures and management incompetence – became impossible to ignore. 

However, embarrassingly Lloyds and its largest shareholder, the UK government, had ignored repeated warnings about these in elevating the Co-operative to its favoured bidder.

Sabadell’s initial approach to Lloyds for TSB only came at the end of February and the deal was announced in mid-March. An initial tranche of 9.99% of shares was completed by the end of March and Lloyds has irrevocably agreed to sell the remaining 40% stake after regulatory approvals are granted. 

TSB was advised by Citi and Rothschild, and Sabadell by Goldman Sachs.

Sabadell will be hoping to emulate Santander’s success in the UK, but in the SME-lending sector rather than the retail sector. 

TSB has just 4% of UK current accounts. It made a net profit of £134.5 million last year, which was down from the £185 million it made in 2013. Sabadell’s offer of 340p per share values the bank at £1.66 billion – a 30% premium to TSB’s June IPO. Shares in Sabadell fell 7% on the news of the merger. 

Lloyds will take a £640 million charge on the sale, which reflects the costs of the transaction and a £450 million payment by Lloyds to TSB to fund its IT operations.

Stark change

The deal marks a stark change in tack for Sabadell, which had been focusing on domestic acquisitions. It has history with Lloyds, having bought the UK bank’s unprofitable Spanish business in 2013. 

Sabadell management has played the opportunity presented by the European Central Bank's sovereign quantitative easing very well, and its earnings have been supported by a very aggressive carry trade in Spanish government bonds.

Sabadell has a government bond portfolio of roughly €25 billion, which is equivalent to close to three times the capital of the bank. The portfolio has a relatively long duration of 5.2 years with a yield approaching 3%. 

The portfolio was built up at the height of the crisis and Sabadell has recorded material gains as a result: €2.5 billion in trading profits over the last five quarters. 

However, as these bonds mature the bank faces losing these revenues of 3% on €25 billion, which represent around 20% of the underlying revenues of the bank. That is quite a headwind and could be a factor behind its decision to diversify into the UK.

Yet the move on TSB could end up being more expensive for Sabadell than it initially appears. The deal could end up requiring the Spanish lender to raise more capital for its new UK subsidiary at a time when close attention is being paid in Brussels to the nature of its existing capital base. 

Deferred tax assets account for more than 70% of Sabadell’s core capital – the second highest proportion in Europe behind only Bankia, which has 80% – but are now under investigation by the European Commission as to their eligibility as such. 

It might also find the UK market tougher to crack than its larger Spanish rival, given that it is starting from a lower base in a more competitive market. 

As much as the UK government is keen to encourage challenger banks, other foreign players with a similar strategy have come unstuck. National Australia Bank, which owns UK challenger banks Clydesdale Bank and Yorkshire Bank, stated last year that exiting the UK is "an absolute priority" and plans to float the banks.