How Italian banks built new foundations

Peter Koh

Monday, November 27, 2006

Rarely has a country’s banking system experienced such an overhaul in such a short space of time as Italy’s has over the past 12 months. The urge to merge has made banks team up with local rivals to avoid being gobbled up by a foreign competitor. The foundation ownership system set up in the 1990s is losing its grip. Peter Koh reports from Milan and Rome.

Politics in and out of the boardroom
Divorce Italian style
Monte dei Paschi looks to the future

ON JULY 12 2006, Mario Draghi, the governor of the Banca d’Italia, gave a speech at the annual meeting of the Associazione Bancaria Italiana in which he urged the chairmen and managing directors of Italy’s banks to consolidate for their own good or look on as foreign players took an even greater share of the market.

After the takeovers of Antonveneta by ABN Amro and Banca Nazionale de Lavoro by BNP Paribas, completed earlier in the year, Italian bankers hardly needed reminding of the problem by the central bank governor.

Clearly, though, his audience must have been paying close attention. Less than three months later, Banca Intesa and Sanpaolo IMI, the country’s second- and third-largest banks, announced their intention to merge, in a €65 billion deal. The market applauded the industrial logic of the deal, which will create one of the largest eurozone banks and the largest player domestically in Italy, even though the transaction was cobbled together in less than a month. Intesa had previously been considering a deal with Capitalia, and Sanpaolo IMI had been linked with Banca Monte dei Paschi di Siena. The merger announcement marked a surprise rejection of those deals. Intesa and Sanpaolo IMI now expect to complete their merger by the end of next year. The new entity is to be called Intesa Sanpaolo. There have been a lot of mergers and acquisitions between Italian banks in the past two years and there are still more to come. The pressure now mounts on Capitalia and Monte dei Paschi.

“Italy is actually the only large country in continental Europe where the banking sector is totally privatized,” says Corrado Passera, CEO of Banca Intesa. “This strong injection of competition has definitely pushed the consolidation process in our country, giving Italy the chance of creating banking groups that have the strength and the awareness to be competitive with the best European players. The merger of Banca Intesa with Sanpaolo IMI will be a result of this process.”

Passera sounds pleased with the deal he eventually struck because he says it enables him to take the fight to the big international banks. “Thanks to the merger the new combined group will rank first in Italy in many sectors even before synergies,” he says. “It will have the assets to act as one of the leading players in the international banking system and have the capability to more easily explore growth opportunities that otherwise were not achievable. We would like to establish or increase our capability to support our corporate customers in countries like India, Russia and China and to develop our presence in the countries where we own local banks.”

The announcement of the merger had a galvanizing effect on the rest of the Italian banking sector. Just two months later, in October, four cooperative banks (popolari), fought for control of Banca Popolare Italiana, the former Banca Popolare di Lodi whose chairman, along with the former central bank governor, Antonio Fazio, had brought the close ties between the country’s banks and its former regulator into disrepute a year earlier during ABN Amro’s tortured takeover battle for Antonveneta. That deal, which battered down the gates to the Italian market for other foreign players, most notably BNP Paribas, exposed, in tabloid fashion, just how close the links between politics and banking had become. But those links were not strong enough to withstand the market forces pressing for consolidation.

This November the Banche Popolari Unite group agreed a deal to buy Banca Lombarda for €6.15 billion to create Italy’s fourth-largest branch network, and two regional banks, Cassa di Risparmio di Firenze and Banca delle Marche, were reported by financial newspaper Il Sole 24 Ore to be in discussions.

Delighted bankers

And the bankers in the middle of all this deal making, far from being upset at the dismantling of the old order, are delighted with this level of activity.

“Intesa Sanpaolo will have the assets to act as one of the leading players in international banking” Corrado Passera, Banca Intesa

Even the unrelenting drizzle in Milan has been unable to dampen the new vigour in its bankers’ footsteps. “People have been waiting so long for something to happen and now at last things things are moving,” says one of them. “It’s been a bit like waiting for the bus. You wait years for a merger and then suddenly they all come at once.”

Italy’s banking sector has undergone real and impressive changes over the past 15 years and the pace of change is now accelerating. But even though the country has finally opened its doors to foreign competition in this wave of consolidation – its second since the late 1990s – and the market is pleased with the rationale behind recent deals, the influence of politics has not disappeared. Politics might have taken a back seat but politicians are notorious back-seat drivers.

However, the driver’s seat is also getting more crowded: in all the recent domestic deals, management boards have agreed to let German-inspired supervisory boards share responsibility for setting the direction of newly merged banks.

Italy’s banking foundations, created during the privatization process in 1990 and made up largely of political and politicized appointees, remain influential and sometimes controversial shareholders in many banks. Draghi’s announcement in late October that the 30% cap on foundations’ voting rights could be reconsidered so as to reflect their higher actual ownership sounds reasonable. In reality, though, it is a retrograde step.

The law that caps the voting rights of the foundations was introduced in the early 1990s as part of privatization to reduce the influence of the foundations on the banks. At the same time, foundations were required to reduce their shareholdings to less than 50%.

Some foundations, however, reluctant to cede control, have sought to get around these restrictions through shareholder pacts with other friendly institutional investors, often other foundations. The foundation of Siena, for one, sought to get around this restriction by converting 10% of its 59% holding of Monte dei Paschi di Siena’s ordinary shares into preference shares.

The foundation of Siena has more reason than most to want to maintain a tight grip on its bank but its motivations and concerns are typical. Monte dei Paschi is the city’s largest employer, accounting for roughly a third of its population. A popular joke in Siena is that there are only three types of people in the city: those that work for Monte dei Paschi; those that have retired from it; and those that are waiting to work there.

Monte dei Paschi is an extreme example. However, the foundations of Genoa and Florence also wield considerable influence on Carige and Carifirenze, respectively, and nearly all of Italy’s banks have significant foundation shareholders. So lifting the cap on voting rights will strengthen the hand of foundations and therefore politicians across much of Italy’s banking sector.

“It is absolutely a step backwards,” says a bank analyst at an Italian investment bank in Milan. “The original goal of the law was to reduce the influence of the foundations. The right-wing coalition led by Silvio Berlusconi wanted to reduce the power of the foundations because they are full of appointees made by the previous left-wing coalition. Now that the left is back in power, however, this law limiting the influence of the foundations is no longer welcome.” It’s an issue that cuts to the heart of the consolidation process.

The size of foundations’ shareholdings means that they are always crucial to getting any merger voted through. Although many have been supportive of deals in the past, even those that have diluted their holdings and influence, the potential for conflicts of interest is obvious.

Divergent evolution

The most interesting future M&A questions surround Capitalia and Monte dei Paschi, Italy’s third- and fourth-largest banks, which are both widely believed to have been in talks of their own about possible combinations with respectively Intesa and Sanpaolo IMI shortly before the larger two announced their surprise plan.

Despite having a common grievance with unfaithful partners, the jilted parties are unlikely to seek solace in each other’s arms. The two look intent on divergent paths.

Capitalia CEO Matteo Arpe, whose bank has a number of foundation shareholders but none with more than 7%, sees a deal of some kind as an integral part of his strategy; Monte dei Paschi, by contrast, is focusing on its standalone business plan while considering the possibility of acquisitions.

Speaking to analysts recently, Arpe made clear that a deal, preferably with another European bank, was part of Capitalia’s strategy over the next few years. “We confirm that our strategy does not exclude the possibility of mergers, but rather includes it,” said Arpe. “The market has changed for the good and we need to change with it. But doing nothing or rushing into a deal are both wrong strategies. Capitalia is in a strong position because we are both interesting to others and interested ourselves.”

“Doing nothing or rushing into a merger deal are both wrong strategies” Matteo Arpe, Capitalia

Although careful to speak in the hedged language of investor relations, Arpe hinted at his preference for an international deal. “When considering mergers you have to take a dynamic view of the market,” he said. “As the market moves, new opportunities arise. The developments in Italy are in parallel to developments in other countries in Europe. We are all moving towards a European market, so it’s necessary to look two to three years down the line. While speculation over the next few months is likely to remain focused on the domestic market, in the longer term things are moving towards the European level.”

Although Monte dei Paschi is currently trading at a 20% to 30% premium to its peers largely on the basis of merger speculation, Antonio Vigni, the bank’s general manager, emphasizes his view in an interview with Euromoney that the bank’s industrial plan, which focuses on efficiency improvements, product alliances and expanding customer relationships, and which does not focus on a merger, is the best response to the consolidation taking place in Italy (Monte dei Paschi looks to the future, Euromoney December 2006).

The role of Mediobanca, with its legendarily complex web of cross-shareholdings, in consolidation activity is still anybody’s guess. The Milanese investment bank is keeping its cards close to its chest and for now seems content to play its traditional advisory role. The bank is advising Monte dei Paschi on finding a partner for its insurance business. And it advised Banca Popolare Italiana on its search for a partner.

Stable foundations

For every critic of the foundations there are at least as many supporters.

In his speech to the ABI in October, Draghi praised the contribution of the foundations to the banking sector.

“Foundations are not something that prevents a market approach to business,” says Ranieri de Marchis, CFO of UniCredit. “They are long-term investors focused on value creation like any other shareholder. They are a benefit to many banks because they provide stability. Our foundations have always supported us in our strategic decisions.”

Foundations have also used their influence over banks in a way that benefits other shareholders too.

The aim of foundations, which are non-profit organizations, is to use the dividend income from their shareholdings in the banks to fund pet social projects in their regions. As a result, foundations favour high dividend payout ratios and, at least partly because of that, Italian banks offer relatively higher dividend yields than many others in Europe.

The influence of foundations has hardly protected Italian banks from the sort of changes that have been sweeping through the industry across Europe.

“Italian banks have been an extraordinary case study in restructuring and de-risking,” says Matteo Ramenghi, an Italian banks analyst at UBS in Milan. “They used to be undercapitalized and inefficient; today they have excess capital, they are efficient and they are gaining pan-European scale. Management changes were key to such a transformation.”

Many Italian bankers are frustrated that only myths about their industry persist.

“There is a misperception that margins in Italian banking are particularly high,” says UniCredit’s de Marchis. “It’s misleading to compare products individually, you really need to look at the whole picture. While it may be true that mortgage spreads are higher in Italy, it has to be remembered that repossession times are also a lot longer here. In the UK a repossession can be done in a matter of weeks but in Italy it can take years, so the spread is justified. The idea that Italian bank services are overpriced is more perception than reality.”

Antonio Fazio, the former central bank governor, contrived for years to block outright foreign takeovers of Italian financial services companies but he never succeeded in blocking foreign competition entirely, even in the most attractive growth segments. Among the facts that Mario Draghi, his replacement, used to exhort the country’s banks to consolidate were that foreign-owned institutions already controlled 29% of Italy’s rapidly growing consumer credit market and that foreign-owned asset managers now manage 25% of all the investment funds marketed in Italy.

Competition, he pointed out, had also narrowed the spread between the average lending rate and the average cost of funds from 5.8% to 3.3% over the past 10 years, a figure in line with the eurozone average.

Figures from the ABI also show that market share in Italy’s banking system is a lot more contestable than in other major markets (see graph).

FEWER, BUT STILL TOO MANY?

Number of banks in Italy

Source: ABI

Although Italy’s banking sector has been in constant revolution since privatization began in 1990, it is only now that the sector is embarking on its second wave of consolidation that people are starting to realize just how far things have already gone.

“There was an unprecedented amount of change that was blocked for the last 15 years,” says Antonio Villalon, a senior M&A banker and vice-chairman of Lehman Brothers. “But if a €65 billion merger can be put together in just three to four weeks, what can’t be done?”

Bella Italia

According to the ABI, there have been well over 600 mergers among Italian banks since 1990 and the number of banks has fallen from more than 1,000 in 1990 to about 780 today. That is still be a lot but there are 2,400 banks in Germany.

Nevertheless there clearly remains much room for consolidation and the Italian market is attractive for a number of reasons, particularly to foreign banks such as BBVA and Santander, which are both thought to be keen to make an acquisition.

The first is that the Italians are big savers, and deposits are a more attractive way to fund lending than the capital markets. Although the savings to GDP ratio has fallen from the 20% of the past, it is still at 12%, high by European standards.

The second reason is that the penetration of retail lending in Italy is low, with much room to grow. Partly due to past traumas associated with the lira, and partly for cultural reasons, Italians have been reluctant borrowers. This is changing, as the growth in mortgage and consumer lending looks set to feed growth in the banking sector faster than the economy overall.

The other attraction is that pension, insurance, and asset management products all remain relatively underdeveloped.

These features carry echoes of those that attract developed world banks to acquire in emerging markets.

Small company culture

The scale and accessibility of these opportunities is unique among mature markets. But the predominance of small companies in the economy presents challenges to the banks. “The concept of segmentation in Italy is a difficult one,” says Francesco Spinelli, deputy chairman of Antonveneta. “Ninety-five percent of Italian companies have fewer than nine people working for them. Deciding which is a corporate account and which is a high-net-worth individual account is not so easy. Knowing your client and the market is much more important than client segmentation per se. From that point of view Italy is quite different from other countries in Europe. The strength of the economy is in these companies, which makes for potentially very interesting cross-selling opportunities.”

M&A is often contagious, particularly when there is a radical deal that significantly alters the competitive landscape. The merger between Intesa and Sanpaolo IMI, which will create a bank with a much greater market share than the next largest player or any other, is just such a deal.

But while no bank is immune to the factors prompting further consolidation, some banks see it more as an opportunity than a threat and there remains plenty of room for smaller players.

“On the corporate side it means there are fewer banks to compete against and on the retail side the networks will often remain capped at the size of the old networks,” says Jean-Laurent Bonnafé, CEO of Banca Nazionale del Lavoro and head of retail banking at BNP Paribas. “So it’s really more of an opportunity than a threat. We didn’t enter the market with the goal of capturing 10% to 20%. We came in to offer a wider product range and a better service. If we succeed then our market share will increase. If we were entering today we would have moved in exactly the same way.”

Persistent localism

Small banks in Italy might have a better chance of survival on their own than their peers in many other countries because of the strong local character of banking in Italy. “Local banks still exist and flourish and there is no reason to predict their disappearance,” says Alberto Buffa di Perrero, a director at Standard & Poor’s in Milan. “There are about 400 banks in Italy with just five to 20 rural branches. One effect on the mid-sized and small banks of consolidation over the years has been that they have actually gained market share from those that have merged, as management tends to get distracted by organizational complexities and loses its focus on local issues.

“These smaller banks might be less competitive in terms of costs because they can’t leverage economies of scale but their pricing power with local customers is very good. Customers appreciate the value of local presence and are willing to pay for it.

“The unification of Italy was quite recent. In the Middle Ages Italy was the land of city states and this has remained in people’s way of thinking.”

Ranieri de Marchis, CFO of UniCredit, says: “There’s always room for the big guys, the middle guys and the smaller guys. It’s not a question of room but of business model. You can be a small niche player but you need a business model that makes that work. Size is not necessarily a factor for success. There are big banks that aren’t as successful as small ones. What banks need to avoid is getting trapped into a position that isn’t adequate. You don’t want to end up a mid-sized player because of what’s happening around you, it has to be out of choice.”

Italy’s banking sector has come a long way since privatization began in 1990 and the Mussolini-era law that made it difficult for banks to expand outside their own region was repealed. Back then Italian banking was often described as a “petrified forest” full of archaic failing institutions. The sector today bears no resemblance to that state of affairs.

Although the sector remains fragmented, Italy’s banks are by and large efficient institutions and now two of them are in the ranks of Europe’s top 10. One, UniCredit, is much admired and arguably the first pan-European bank, with a substantial presence in four significant markets (Italy, Germany, Austria and Poland) and substantial interests in many others in central and eastern Europe.

Degree of contendibility in European banking markets
Breakdown by banks' legal structures and their share of total assets
	Italy		Spain		France		Germany		Austria
Commercial banks (Spa)	81%	Commercial banks	60%	Commercial bank	60%	Commercial banks	34%	Special purpose banks	9%
Foreign-owned banks	4%	Cooperative banks	5%	Specialised financial institutions	1%	Large commercial banks	22%	Building and loan association	3%
Listed mutual banks	10%	Savings banks	35%	Finance companies	14%	Regional Institutions of cooperative banks	3%	Joint stock banks and private banks	33%
Cooperative banks	5%			Municipal credit institutions	25%	Regional giro Institutional	18%	member state credit instiutions	1%
						Cooperative banks	9%	Volksbank credit cooperatives	5%
						Savings banks	14%	Raiffeisen credit cooperatives	23%
Contendible market share								State mortgage banks	8%
Non-contendible market share								Savings banks	18%
Source: ABI from OECD and central banks data