France: Breaking the foreign taboo

It is a measure of the crisis gripping France’s banking sector that two of the country’s most respected financial institutions, Paribas and Banque Indosuez, have recently turned to US management consultancy McKinsey to advise them on restructuring their businesses. “This is breaking a taboo in a country as anti-American as France,” jokes one investment banker. “They must have been pretty desperate to take such a step.”

Both banks are struggling with low profitability and the costly legacy of over-ambitious expansion strategies in the 1980s. But their decision to tackle these problems with restructuring plans designed by American consultants, stressing such Anglo-Saxon virtues as focus, profitability and management accountability, is seen as a sign that the ill-health of the financial sector is finally forcing French bankers to rethink the way they do business.

Last year was another bad year for French banks and this one promises to be little better. Their profits continue to be low, provisions against bad loans remain high, rating agencies have been busy lowering their assessments across the sector and domestic competition is more intense than ever.

Hardly had the 1995 results season got under way at the end of February when confidence was dealt another blow as Paribas reported a Ffr4 billion ($800 million) loss for the year, far greater than most analysts had anticipated. The losses arose for a host of familiar reasons – property provisions of more than Ffr3 billion, a large write-down in the value of the group’s 30% stake in Navigation Mixte (acquired during the late 1980s), and losses at the investment banking arm caused by poor trading results. This did nothing to lift the market’s gloom.

Downturn prompts changes

Against this stark background, bankers are beginning to accept that they can no longer wait for an upturn in the economy to bail them out. “People are starting to realize that even the largest banks in France ­p; the universal banks like SociŽtŽ GŽnŽrale and Banque Nationale de Paris (BNP) ­p; shouldn’t try to do the same job and cater for the same customers,” says Jean Jacques Ogier, director in charge of corporate planning at SociŽtŽ GŽnŽrale. “There is room for differences in focus, and for different strategies.”

Focus was the key to the Banque Indosuez restructuring plan announced at the end of January. It involved the closure of offices in 15 countries, including commercial banking operations in the US ­p; something of a departure from the bank’s traditionally expansionist approach. “I think this represented an admission that they could not compete with the global players like the Anglo-German investment banks in London and the American bulge-bracket firms,” says one analyst. Instead, Indosuez announced a new, more modest objective ­p; that of becoming a leading integrated investment bank in France, the Middle East and Asia.

Other banks are toying with similar ideas. At SociŽtŽ GŽnŽrale, the poor profitability of the group’s retail banking operations is forcing it to concentrate on building up its capital markets and investment banking operations. “We are looking at business lines where we have a competitive advantage,” says Ogier, citing FIMAT, the group’s futures broking operations as well as its derivatives business. SociŽtŽ GŽnŽrale is also looking to develop organically its presence in investment banking. “We have tried to build this up over the last few years, but we aren’t ready for a sudden evolution like an acquisition,” he says. Hence the bank took no interest in the merchant bank auctions going on in London last summer.

There are also implications for the retail-banking business. “If conditions continue to deteriorate,” warns Ogier, “we may become convinced that there is no future in retail banking for an institution like SociŽtŽ GŽnŽrale. This would be a thunderbolt decision. But you can’t exclude it. Maybe not tomorrow, but in the future it could happen.”

French bankers are being forced to contemplate dramatic changes of direction because of the persistent downturn in their domestic market. The sector’s ills, one banker says, are akin to a bout of flu that the sufferer finds impossible to shake off.

Many of the problems are cyclical. Mounting corporate losses during France’s long recession, increasing numbers of client companies going bust, and falling demand for consumer-credit, have conspired to drive down their profitability. These woes have been compounded by downturns in capital market activities around the world.

There has also been the banks’ heavy involvement in real-estate development, much of it conceived during the economic boom at the end of the 1980s. Even today, while there are faint signs that the French housing market may be recovering ­p; partly boosted by zero-interest loans introduced by the government in recent months ­p; there is no sign of any corresponding turnround in commercial property. Rating agency Standard & Poor’s recently estimated that the banks’ unrealized losses on property could still be as high as Ffr200 billion.

There are also the high-profile problem loans, such as those to Eurotunnel, the Channel tunnel operator. In October, the company exercised its right to suspend interest payments on its Ffr60 billion of junior debt, more than a quarter of which was held by French banks, thus triggering a further round of provisions.

There seems to be no end to this cycle of woe. The most recent signs suggest that recovery is still some way off. Economic indicators point to a renewed slowdown in consumer spending, while anecdotal evidence shows low public expectation of any upturn in the economy. Most observers agree that things were not helped by the wave of strikes in the public sector over the Christmas period. “People in France are still frightened of debt,” says Michelle Debonneuil, chief economist at Banque Indosuez.

Curbed privileges

In the retail sector, the main response has been intensifying competition, and fierce fighting over interest rates. Jean Peyrelevade, chairman of CrŽdit Lyonnais, felt justified last summer in complaining about the activities of some banks, notably France’s mutual and savings banks, which he said were undermining the profitability of the sector by offering uneconomic loans.

The effect can be seen in the return on equity achieved by the country’s leading retail banks. Even CrŽdit Commercial de France (CCF), regarded as the country’s best big bank because of its limited exposure to property, struggles to achieve a return on equity of 10%, half the level achieved by the UK’s leading banks. As one analyst puts it: “The biggest problem for retail banks is one of revenue. Costs are certainly a problem, too, but the main problem is a lack of revenue.” This assessment is borne out by figures produced by the Association of French Banks, the trade association representing most of the country’s retail and commercial banks. In 1994, the association’s members’ total revenues fell for the first time in 50 years ­p; down 5.5% to Ffr238 billion. In the same year, they reported losses between them of more than Ffr12 billion.

In corporate banking, the situation is little better. Corporate credit demand has been shrinking since 1992, having grown at a rate of 16% per annum over the five preceding years, while new equity issue activity has been tailing off, because of the poor performance of the stock market and the fading momentum of the government’s privatization programme. The latter tailed off sharply last year, with the government raising only Ffr25 billion from the sale of corporate assets, less than half the Ffr60 billion achieved in 1994. This year, with troubled giants such as Air France and Renault notionally on the block, the prospects for early and remunerative privatization business seem even more remote.

Investment banks have turned to proprietary trading to offset the decline in other areas of their business. “Paribas in particular has become very dependent upon proprietary trading for its profits,” says Jacques-Henri Gaulard, banking analyst at James Capel in Paris. The risks inherent in this approach were seen recently when Ffr250 million in unauthorized trading losses were discovered in the group’s Spanish government securities trading subsidiary, leading to the dismissal of two traders. “This is just one of a number of casseroles [cock-ups] at Paribas,” says Gaulard. “They are giving the market the impression that they have very poor controls.” Poor controls were also blamed for a Ffr700 million loss on swaps earlier in the year, which contibuted to Banque Paribas reporting an overall loss of Ffr551 million for the year. These results, say analysts, are not unconnected with the departure in January of the bank’s capital markets chief Patrick Stevenson.

For Ogier, of SociŽtŽ GŽnŽrale, the main worry is the situation in the retail-banking sector. “It’s acceptable for us to be in a market where there are public and private institutions, as long as the rules of the game are the same for everybody,” he says. “Unfortunately, this is not the position at present in France.”

Here he is echoing the strong reaction of the private-sector banks to practices they regard as unfair competition. Most notably, this involved a concerted public protest last year by SociŽtŽ GŽnŽrale, BNP, and CCF, against the amount of taxpayers’ money that may be required to rescue CrŽdit Lyonnais. SociŽtŽ GŽnŽrale has also been among the leaders in protesting against two special state-backed, tax-free deposits: the Livret Bleu reserved by the state solely for CrŽdit Mutuel and the Livret A for the post office and the Caisse d’Epargne savings banks. CCF’s chief executive, Charles de Croisset, likens this privilege to “a supermarket having a monopoly on the sale of red meat” and Ogier insists that its reform is a prerequisite for restoring the banking sector to health.

In pursuing their demands, the protesters have been partially successful. The government recently agreed to some reform of the system, paring away part of the monopoly, and creating a new tax-free deposit to be distributed by any bank. But this did not appease the private-sector banks. They say they would have preferred to see the system abolished entirely.

Tough questions

Ogier believes that if retail banking is again to become an attractive business for SociŽtŽ GŽnŽrale, it needs radical restructuring.

Bank mergers are needed to reduce some of the overcapacity. France is one of the most overbanked markets in Europe, second only to Germany, with 800 branches per million inhabitants. In recent months there has been much talk about putting certain banks on the market. AndrŽ LŽvy-Lang, chairman of Paribas, has said the group intends to dispose of its troubled retail-banking subsidiary CrŽdit du Nord unless the bank achieves satisfactory profit levels this year. And insurance giant GAN, which is slated for privatization, has said it will sell its banking subsidiary CrŽdit Industriel et Commercial (CIC), France’s seventh largest bank.

SociŽtŽ GŽnŽrale has said it is interested in buying CIC, but Ogier remains sceptical whether any deal GAN would accept is likely to make commercial sense. This is partly because any acquisition would involve rationalizing branch numbers and sacking staff. However, archaic working practices, and restrictive labour laws dating back to the days when most banks were state-controlled, make this very difficult to achieve. “This is the problem,” says Ogier. “If two banks try to merge, the French system is pretty much blocked. No-one wants to fire thousands of people under current circumstances.” Few people expect any meaningful reforms of the labour laws while unemployment remains a major political issue in France.

Given these impediments, Ogier says SociŽtŽ GŽnŽrale is likely to continue focusing on the development of its commercial and investment banking activities. Following a similar path is BNP which has recently set itself up as a competitor to SociŽtŽ GŽnŽrale in the derivatives markets.

But it is at Paribas and Indosuez that perhaps the most significant changes have taken place. Both have found themselves threatened by the dramatic changes taking place in investment banking, as global players have started to emerge from among the larger US firms and from the mergers of UK merchant banks with continental universal banks. Five years ago, Paribas and Indosuez were up there with the pack. In 1989, Indosuez even challenged Deutsche Bank in the auction of Morgan Grenfell. Now they are perceived as also-rans.

Global pretensions

Dominique Hoenn, a member of the management board at Paribas, admits that his bank was shaken up by the sudden spate of merchant bank takeovers in London last year. “It was certainly a worry for us,” he says. “These UK merchant banks were our main European competitors, and now they don’t exist. They have been taken over by huge commercial banks whose strategy at present seems to be simply to chase market share.”

This factor has driven home to Paribas how difficult it will be for the bank genuinely to compete as a global investment firm, one of its pretensions until it became beset with problems. “We do see ourselves as a global player,” says Hoenn. “But if you mean by global investment bank that we must provide every type of product for clients anywhere in the world, I would say that is not what we are going to do. In the US, for example, we have no desire to be a competitor to Merrill Lynch, selling US products to US clients.”

Hoenn explains that the bank’s strategy is to achieve global coverage in certain areas, while pursuing other business streams on a more ad-hoc basis. The bank tends to stick to regions where historically it has enjoyed strength. “The main business stream for Pari-bas is in fixed income,” he says. “Therefore, we intend to be a global player in treasury bonds, with a presence as a primary dealer in all the major markets.”

On the other hand, there will be less emphasis placed on expanding the firm’s equity business. “There is a focus in equities and that focus is Europe,” he says. “We are committed to being able to distribute equity products to any European customers.” Outside Europe, there are a few other regions where the firm has a presence which it intends to maintain. These areas include Asia and Latin America, though these are, Hoenn says, “more related to history than any other choice”.

Paribas has already undergone an internal transformation of its organization, courtesy of its McKinsey exercise in 1994. The bank’s management structure has been reorganized globally along product lines, in place of the traditional system which involved local offices managing their own affairs. Now the bank is taking this a stage further, with the introduction of what it calls the “senior banker principle”. This involves the creation of a small group of managers ­p; 20 in total ­p; who are not attached to any product area. These managers are assigned to handle certain of the bank’s clients, and their job is to promote the selling of all the bank’s services to those clients.

Yet while these reforms seem individually impressive, many analysts question whether Paribas has changed all that much. There are, they say, a great deal of unanswered questions about the group.

One concerns the group’s unwieldy structure. Although AndrŽ LŽvy-Lang has promised to sell the weak retail-banking sub-sidiary CrŽdit du Nord unless it comes right in the near future, analysts remain perplexed by the group’s odd mix of businesses. Compagnie Bancaire, the 47%-owned specialist financial services subsidiary, is a curious rag-bag of companies, including a large number of property subsidiaries which have been heavy loss-makers. “If you look at Compagnie Bancaire,” says Gaulard at James Capel, “it has one really good asset, the leading French consumer finance house Cetelem. That firm made all the money in the group last year, and in 1993, and in 1992.” He believes that Paribas should break up Compagnie Bancaire, keeping only Cetelem and selling off all the other parts.

Another conundrum is Paribas Affaires Industrielles (PAI), Ffr40 billion portfolio of equity investments beneficially owned by Paribas, which seems semi-detached from the rest of the group and exceeds in value its market capitalization by nearly Ffr10 billion. Traditionally, the investments existed, in theory at least, as a way for Paribas to buy banking business ­p; other banks were then not allowed to be active investors in industry and the bank sought to make money out of the relationship by selling banking services to those companies in which it had an investment. But this arrangement broke down in the 1980s and, ever since, although PAI has been a steady (and in recent years the biggest) profit contributor to the group, analysts have questioned whether the capital would not be better used elsewhere.

Hoenn refuses to be drawn on the question of PAI. “We still maintain that investing in corporations is a good thing for us to do,” he says. But following the group’s poor results, which saw a write-down of Ffr2.1 billion in its 30% shareholding in Navigation Mixte and only Compagnie Bancaire contributing profits from elsewhere, Paribas announced the disposal of Ffr15 billion of unspecified assets. Analysts see this as a first step to unwinding PAI and reinvesting the capital in the group’s core business.

Paribas is likely to have the luxury of dealing with problems in its own way because it is protected by what analysts call the “spaghetti system” of cross-shareholdings, with 35% of its capital tied up by four shareholders, including insurance giant Axa, Navigation Mixte, and Pargesa. No-one expects these shareholders to take a hostile stance in shaking the company up.

A crippled bank

Banque Indosuez, on the other hand, has been less fortunate. It had to contend with a single troubled shareholder ­p; the industrial and financial holding company Suez ­p; and its new restructuring plan perhaps reflects the brisk approach of its parent’s new chairman, Gerard Mestrallet.

Indosuez was a crippled bank. Weighed down by almost Ffr10 billion of property loans and investments, more than half of which were doubtful or bad, the bank was in no position to weather the prolonged downturn in the banking sector. In 1994, Indosuez reported a net loss of Ffr1.1 billion, following write-offs for property loans and investments of Ffr2.4 billion. Suez was forced to inject Ffr1.1 billion of new equity just to allow the bank to meet the minimum international banking standards. The situation put Suez into an acute dilemma.

Despite its capital injection, Indosuez clearly required further restructuring and doubtless additional capital. The parent had to decide whether to stand by its subsidiary or cut its losses and sell. Disastrously, Suez followed both these courses. Under its previous chairman, GŽrard Worms, the group held discussions about the possible sale of Indosuez. Then Worms was forced out and Mestrallet, the incoming boss, quickly gave a categorical assurance that Indosuez was an integral part of the Suez group and was not for sale.

Mestrallet admits that the uncertainty caused what he describes as “trouble at the heart of the bank”. There were defections of both staff and clients. “The entire Forex team walked out and went to CrŽdit Lyonnais,” says Gaulard at James Capel. “This was very damaging because foreign exchange was a big earner for the bank.”

But having given his assurance that Indosuez would remain within the Suez group, and effectively agreeing to put up further capital to allow the bank to rebuild its damaged business, Mestrallet had every incentive to exact some tough conditions for the refinancing. The Indosuez restructuring is perhaps the most radical and Anglo-Saxon of any overhaul to be attempted so far.

It has been effectively cleansed of its property exposure, with Suez taking over Ffr5.6 billion of Indosuez’s more risky assets. “Indosuez is the only French bank completely relieved of [this involvement],” says Mestrallet. Suez has also disposed of its 75% stake in the UK fund management company, Gartmore to NatWest Markets, for £472 million, a decision taken partly because it competed with Indosuez Asset Management for clients, but mainly, analysts say, in order to raise the finance needed to recapitalize Indosuez ­p; Suez has promised a contribution of Ffr1 billion.

The fresh capital, however, comes with strings attached. The bank has agreed to cut operating costs by Ffr250 million to recapitalize Indosuez and to achieve a return on equity of 9% within three years. “It’s a pretty stiff task when you think that Indosuez has never achieved this,” says one analyst, who remains sceptical about the bank’s ability to meet its targets.

Furthermore, Mestrallet has taken a scalp ­p; that of Francois Lepetit, the deputy chairman of the bank. “I think when organizations go through a new phase in their existence, you have to have a new patron,” he recently explained. “The more significant the change, the more important that is. Ten years ago in France it was not the case, but now France is becoming more Anglo-Saxon. We needed a breath of fresh air.” Lepetit has been replaced by Christian Maurin, who was formerly head of Suez’s Sofinco subsidiary.

In attempting to meet its targets, Indosuez will have less territory to play. A key aspect of the agreement with Suez is that the bank will shrink its markets to those regions of the world where it already has a strong presence. Indosuez has thus abandoned any ambitions to be a global player in investment banking. “We are of medium size, we have to admit it and we have not always done so in the past,” says Maurin.

A final aspect of the agreement with Suez relates to credit quality. Downgradings in recent years have led average ratings for the leading French banks to fall to the brink of investment grade. This damages their derivatives business and other capital markets activities. But most banks need to be able to offer derivatives products, for instance, if they are going to be able to bid for bond mandates from their clients

Indosuez will be forced to inject almost all of the ffr1 billion from Suez into a ring-fenced vehicle responsible for the bank’s market activities, to ensure an AAA credit rating.

It is perhaps too early to assess the significance of many of the changes going on at French banks. While the downturn since 1992 has forced changes of direction on some of the less fortunate players, much of the architecture of earlier years remains in place.

Although Gerard Mestrallet at Suez and AndrŽ Levy-Lang at Paribas each claims that it no longer matters which school the bank’s employees attended, there is still evidence that the system of pantouflage ­p; whereby civil servants and political advisers shuffle between the public and private sectors ­p; is only slowly being abandoned. Evidence of this can be seen in the case of CrŽdit Commercial et Industriel, which recently appointed a new chief executive to guide it into the private sector. Despite coming under considerable pressure to appoint Pierre-Matthieu Duhamel, a 39-year-old former adviser to French prime minister Alain JuppŽ, the company surprised the markets by appointing a banker, Bernard Yoncourt.

Pantouflage and the spaghetti system continue to hold French banks back. Analysts point out that by protecting managements from the consequences of their actions, such systems simply promote the status quo and negate the need for managers to take tough decisions. “How can managers claim to speak for all the shareholders when they are hiding behind a noyau dur [core block of shareholders],” asks one analyst.

The reality is that only when shareholders have real power ­p; as they do in the case of Banque Indosuez ­p; can radical changes be effected. The same cannot yet be said of Paribas.