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Italian banking: More M&A, per favore

Italian banks may have no choice but to consolidate.

The ties that bind the Italian sovereign and its domestic banking system grow ever-stronger by the day. This year, just like their banking counterparts elsewhere in the eurozone, Italian financial institutions have stepped up government bond purchases, thereby reducing sovereign spreads and, in turn, boosting banks’ share prices.

But this mechanistic relationship has ensured that negative sovereign-bank feedback loops are ever-more structurally entrenched in the Italian financial system. This should intensify pressures on mid-tier Italian banks to consolidate in the coming years given the elevated risks of tighter liquidity conditions and/or rising sovereign bond yields.

The LTROs, through which Italian banks have taken more than €250 billion, are likely to be largely ineffective in encouraging Italian lenders to postpone deleveraging, with SocGen analysts predicting banks will cut lending by €148 billion to €444 billion over the next two years, equivalent to up to 26% of all private sector loans.

Given the prospect of a deposit war – driving net interest margins down further – and a weaker domestic bid for Italian government bonds, the profitability and the funding base of the Italian banking system will be heavily tested. To add fuel to the fire, last month Moody’s downgraded 26 Italian banks, citing earnings pressure and restricted market funding access.

This noxious cocktail of funding risks, lower profitability prospects and declining creditworthiness should set off a wave of mergers and acquisitions activity among Italy’s popolari, or cooperative, banking sector.

Historically, a one-person one-vote system combined with the need for central bank approval for the transformation of popolari banks into joint-stock companies have shielded these institutions from hostile bids. However, market forces – specifically rising funding costs, poor capital generation and increased dependence on the European Central Bank – have thrown into sharp relief the compelling financial logic of business mergers.

Analysts at Nomura say a merger between mid-sized financials UBI Banca and Banco Popolare would be value-accretive for shareholders, with a projected 9% return on tangible equity (ROTE) for the merged entity in its second year compared with 7.4% for UBI on a stand-alone basis. An all-share merger between Banca Popolare di Milano (BPM) and Banca popolare dell’Emilia Romagna (BPER) – which was proposed in 2007 and then rejected by the BPM board, citing corporate governance constraints – would deliver an 8.2% ROTE for the new institution in its second year compared with 7.6% for BPER.

It’s not clear if consolidation will kick in given corporate governance norms and who would lead any consolidation charge. The perennial risk that any M&A premium will exceed the net present value of synergies arising from the associated merger would also loom large.

However, the financial logic for consolidation is compelling given pernicious links between sovereign and bank finance markets, and besieged shareholders in mid-tier Italian financial institutions deserve as much downside protection as they can get.

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