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European banks are going to get much bigger - much bigger. In the quest for a knock-out market capitalization, Europe's bank leaders are ready to tie the knot with the unlikeliest of partners. The coming wave of mergers involving commercial banks will put the recent consolidation of investment banking in the shade. By Peter Lee.

Hungry ING looks for its next meal
US banks dare to cross cultures
A jumble of incentives

Last year there was a huge leap in mergers and acquisitions within the European financial sector. The total value of deals was $107.4 billion, compared with $48.6 billion in 1996 and $46.9 billion in 1995 (according to figures from AMDATA). Last year, roughly one-third of all European M&A deals were in the financial sector. They encompassed financially-driven mergers within domestic markets designed to cut costs; more strategic cross-border deals, as banks with large shares in their own domestic markets sought to expand across Europe; and a growing number of deals between banks and insurance companies.

It's a safe bet that in the final year before the introduction of the euro bank mergers will continue apace throughout 1998. Not surprisingly, financial institution group (FIG) teams at investment banks, which advise banks on their merger plans, are girding up for another hectic year. If the enthusiasts are right there will be some large and surprising combinations this year. "'Think the unthinkable' has become the bank chairman's anthem," says Alastair Walton, managing director and head of FIG for Europe and Asia Pacific at CSFB. "We are showing ideas to bank CEOs that we wouldn't have dared show them 12 months ago. And what's surprised us is that CEOs are already well aware of the concepts if not the numbers behind those ideas. They are already considering them." He adds: "If 1997 was a year to consider and talk about those ideas, 1998 will be the year for action."

Walton's own group has grown from five people in mid-1996 to 17 today and is targeted to expand to 30 by the end of the year. "We're a microcosm for the whole financial-services sector," says Walton. "You've either got to be large or get out of the business. You can think of how rapidly investment banking has consolidated and translate that to mainstream financial services."

The forces driving consolidation in European banking are numerous and well known: overcapacity - there are 3,500 banks in Germany alone, deregulation, loss of national protection and increased competition. These factors will be exacerbated by the single currency, disintermediation in wholesale banking, weak earnings growth in many banking business sectors, the need for scale to spread growing information-technology and processing costs and the rising demands of shareholders for decent returns.

To senior bankers worrying about all these issues, there is no obvious strategic answer, no single model for the ideal bank of the future towards which all are working. But of one thing most bankers are sure: size matters. As a general rule, the bigger the bank, the lower the cost/income ratio. And, unsurprisingly, banks are most profitable in countries where market share is concentrated in a very few hands.

The simple objective of attaining a high market capitalization is a key driver behind many mergers and is often a more important consideration to senior executives than whether a merger creates a better business mix for the new group. "A high market capitalization can dramatically add to a bank's strategic flexibility," points out Andrew Chisholm, managing director at Goldman Sachs in London. With a large enough market capitalization, banks can afford to make hefty investments in technology, they can afford to add on other desirable acquisitions of banks that have expertise in particular products or countries, they can even make mistakes in the process and get away with it.

Any bank that is within the top two or three in its own country today will likely have ambitions to be within the top 20 or 30 in Europe as the single market unfolds over the next five years. Bank chairmen and chief executives are wondering what, in five years time, will be the average market capitalization of the leading banks in Europe. And they are weighing strategies to get their own market capitalizations up to those projected levels.

At the end of 1997, ING, one of the largest banks in Europe, had a market capitalization of $40 billion. Chisholm, working on a rough estimate of 15-20% annual growth, suggests that by 2003 the average market capitalization of a top-10 European bank will be $80-100 million, the average for the top 20 perhaps $60 billion and likewise for the top 30 perhaps $45 billion.

Capital challenge

Even for such large household names as Germany's Dresdner Bank or Spain's Banco Bilbao Vizcaya (BBV), each worth just over $20 billion at the start of this year, those are challenging figures. And they are even more daunting for banks like France's Banque Nationale de Paris whose market capitalization at the start of the year was $11 billion, or Spain's Argentaria and Banco Popular, Denmark's Den Danske Bank or Belgium's Generale Bank (each somewhere between $7 billion and $8 billion). The question is how to get the market capitalization up. One way is to expand the earnings multiple at which shares trade by better management, greater emphasis on producing shareholder value, taking hard choices about pruning businesses, achieving savings and scale and demonstrating a stronger financial performance.

Across Europe banks are showing a surprising enthusiasm for such previously unfashionable disciplines. Barclays and NatWest for example have curbed their ambitions in global investment banking. Credito Italiano has shed staff, closed international branches and emphasized higher margin retail and small-business banking over lending to large corporates. Dresdner Bank has improved its capital management by selling off stakes in industrial companies. European banks have been pushing down their cost/income ratios, (from 73% in 1990 to 64% in 1997 for the leading banks which Goldman Sachs analyses) and improving their returns on equity (from 13.7% in 1995 to 16.2% in 1997).

Such efforts will only push their valuations so far. Chisholm estimates that such organic growth might push a current $10-20 billion market capitalization bank only one third of the way to its target of being firmly in the leading group. In part, that's why so many bank executives are considering mergers to get them the rest of the way. "They all want a seat at the table in Europe," says Walton. "Today banks need scale, especially home-market scale, in order to have any hope of being significant internationally in the years to come."

Of course, banks have been busily merging and acquiring each other in Europe for several years already. A considerable domestic restructuring has been underway throughout the 1990s. According to figures compiled by London-based First Consulting, in the first four years of this decade the number of banks in France declined from 801 to 626, following mergers among the savings banks. In the Netherlands the number fell from 153 to 127. In Germany the number of small cooperative banks fell from 3,221 to 2,591 between 1990 and 1995. Among Europe's smaller banks, the trend towards consolidation has been evident for some time.

For larger banks too, the benefits of mergers and acquisitions have been proved by the growing importance in their chosen markets and improved financial performance of banks such as ABN Amro and ING in the Netherlands, both products of large mergers; BBV (a 1988 merger) and Santander (which took control of Banesto in 1994) in Spain; and Lloyds TSB Group in the UK. "There is a trend towards market leadership. That could be in a market defined by product, a regional or national market or in a global business like investment banking," says Keith Brown, head of FIG at Morgan Stanley. "In the UK the two dominant banks are Lloyds TSB and HSBC Midland, which have both arisen out of mergers and acquisitions. They are now pulling away from the others partly because larger market shares have generated improved profitability. Barclays and NatWest, which used to be the two biggest banks in the UK, are trailing behind." He adds: "The obvious winners in Europe will be those, like Lloyds and Santander, with a dominant position in their home markets."

The single most attractive thing for any bank to do is merge with or acquire a large domestic competitor. Nordbanken in Sweden only did its cross-border deal with Merita as a second choice after its preferred partner, Sweden's SE-Banken announced a merger with insurer, Trygg-Hansa. Similarly, Belgium's Banque Bruxelles Lambert (BBL) only succumbed to Holland's ING after making strenuous efforts over several years to find a domestic partner. Last year witnessed some sizeable domestic mergers and acquisitions: Société Générale and Crédit du Nord in France; Bank Austria and Creditanstalt in Austria; Bayerische Vereinsbank and Hypobank in Germany; Handelsbanken and Stadshypotek in Sweden; Ambroveneto and Cariplo in Italy; and at the end of the year the most remarkable of all: UBS and SBC in Switzerland. "Bank managements are prepared to take a risk on competition policy," says Walton. "Very few major bank mergers have been disallowed in recent years and we're advising that a combined bank can go to 25% market share in retail financial services without worrying. Banks themselves are now taking the single currency as a given and beginning to think in terms of European market share, not national market share."

There is continuing speculation that at some stage Barclays and NatWest will merge, adding another giant domestic combination to the European banking landscape. NatWest has reportedly approached Abbey National and insurance company Prudential over mergers and been rebuffed. Barclays, realizing that the cost benefits of a merger with NatWest would make a great deal for shareholders, has made overtures to NatWest. The main obstacle to such a merger, other than the personal worries of NatWest's management, is that it would create a dominant force in lending to small-to-medium-size UK businesses. It might well be blocked on monopoly grounds by the UK government unless some satisfactory scheme could be agreed for separating out some of the small-to-medium banking business. It would not create a monopoly in UK personal financial services. Not long ago, such a merger would have been unthinkable. Now bankers and lawyers are working on the details of how it could happen. The announcement of a proposed merger might induce Lloyds TSB to make an offer for Barclays.

Last year's deal between SBC and UBS seemed to signal a change in thinking about bank mergers in Europe. It marked a growing acceptance of the need to cut costs and jobs to produce strong banks and less concern over domestic monopoly considerations. The new UBS could have up to a 35% share in the Swiss banking market. The two Swiss giants aim to cut 13,000 jobs from their combined headcount of 56,000 by merging their overlapping domestic and international investment-banking operations. They plan to take out 20% of combined costs within three years. The new group has stated its goal to achieve a sustainable return on equity of 20% by 2002 and a cost/income ratio of under 60%. This looks more like the kind of hard-headed merger that investors in US bank stocks have grown used to in recent years.

Raising the stakes

Though there are few other prospective bank mergers that provide such opportunities for cutting costs both at home and abroad, the SBC/UBS deal is a significant pointer for future consolidation in Europe. It shows a pragmatism over job-cutting that even two years ago would have seemed very un-European. It also raises the stakes in terms of what will be perceived to be the necessary size and scale to maintain a place among the top banks in Europe. And it adds to the general air of urgency and expectation within bank boardrooms. With every deal that is announced, the options for other banks looking for merger partners are reduced and the pressure grows to do some deal or other. "There was enough momentum even before the Swiss deal that you could say every bank in Europe had consolidation on their mind in some fashion," says Chisholm. "When that deal happened it made people realize that no transaction is off limits anymore."

Pressure exerts itself in subtle ways. UBS and SBC might not have come together had not Credit Suisse first made an aggressive approach to UBS. Or take the merger announced last September of Bayerische Hypobank and Bayerische Vereinsbank. Cutting overlapping branches and back-office systems should save over Dm1 billion ($562 million) a year. It gives the new bank the opportunity and scale to shift away from low-return lending to medium-size corporates into higher-margin mortgage banking and asset management. The exchange by Vereinsbank of shares it already owned in Allianz in return for Hypobank shares re-deployed under-used excess capital previously tied up in an industrial equity portfolio. It positions the new bank for a leading role in any future consolidation of German banking, perhaps partnering one of the big three Frankfurt banks.

The logic of putting the two banks together was always apparent. But a deal only happened after Deutsche Bank took its 5% stake in Vereinsbank in the middle of 1996 and Vereinsbank began considering defensive strategies. Even then a deal was only possible because Eberhard Martini, chairman of Hypobank, was approaching retirement age and wasn't ambitious to run the merged bank. "People make mergers, not economics," points out Steven Davis, who runs his own bank consultancy, DIBC. When putting two banks together, the ages of the two chairmen is one of the first considerations. Many FIG teams will not bother suggesting a financially compelling deal if they suspect personality clashes are likely among ambitious senior executives of similar age at the two banks.

Still, there are forces at work other than personal dynamics. Shareholders are becoming more demanding and national and regional governments seem to be taking a more positive attitude towards mergers. The Bavarian government may have been attracted by the idea of Bavaria one day becoming home to the headquarters of Germany's largest bank and showed its favourable disposition by allowing the exchange of Allianz and Hypobank shares to proceed free of tax. "It is increasingly being realized that if a domestic market over-protects its institutions, there is a risk over time of turning them from being potential predators to being the prey," says Chisholm. "Even social commentators are beginning to see the advantages of having larger, stronger banks to preserve jobs in the long run."

Mega-mergers announced in 1997

Month announced Participants Deal value ($bn)
January Bank Austria/Creditanstalt 1.5
May Ambroveneto/Cariplo 3.9
July Vereinsbank/Hypobank 11.9
August Credit Suisse/Winterthur 9.5
October Merita/Nordbanken 4.1
November ING/BBL 5.2
November Paribas/Compagnie Bancaire 4.4
December UBS/SBC 24.4

So the likely future pattern of bank consolidation in Europe looks obvious. There will be continuing in-market mergers driven by a search for scale and supported by the desire for cost-cutting. Once that process nears completion, and assuming the single-currency block of European countries becomes a truly open and competitive market, strong domestic banks will seek more mergers within that block.

Already, some of the smaller countries in Europe have reached the advanced stages of domestic consolidation. Morgan Stanley analysts look at the percentage of total assets in the banking system controlled by the top five banks. Taking figures from the start of last year, in Sweden (86%), the Netherlands (81%) and Finland (74%), the process is furthest advanced. But in Europe's largest economies consolidation has a long way to run, especially in Germany (17%), Italy (29%), France (47%) and even the UK (57%).

For banks in the smaller, more consolidated countries the next step after cementing a strong domestic market share has been to move cross-border. Merita, itself the product of a 1995 merger between Unitas and Kansallis-Osake-Pankki, had already achieved a 40% market share in Finland. With nowhere else to go in its domestic market it entered the first cross-border merger of equals, with Sweden's Nordbanken, late last year. "We are redefining our home market," says Hans Dalborg, former head of Nordbanken, who will be chief executive of the new bank. "The significance of borders between Nordic countries has been decreasing for 10 years and that creates a cohesion."

Similarly, Holland's ING with a large domestic share moved into Belgium, taking over BBL. In both these cases, the participating banks have talked about further cross-border deals, with MeritaNordbanken announcing an open invitation for a Danish or Norwegian bank to join in the creation of a regional super-bank and ING talking of the French-speaking BBL as a platform for a possible move into France.

So will banks in Germany, France, Italy and the UK consolidate in the same way, creating national champions and then expanding across borders? Or will consolidation follow a different pattern in Europe's larger economies? John Leonard, analyst at Salomon Smith Barney, sees potential differences: "Barclays and NatWest are still of sufficient scale to service UK-based clients which expand abroad. I just don't buy the argument that Barclays lacks critical mass globally in the businesses it intends to stay in."

There are also structural issues which may make the pattern of consolidation different in each country. Public ownership of banks is one such issue. In some countries, such as Italy and Germany, up to 75% of the banking system is in the public sector. It may make very good sense for Dresdner and Deutsche to merge or Dresdner and Commerzbank, but even if these private banks do merge with each other they will not achieve dominant market shares. By contrast, the public-ownership figure for other countries is much lower. In the Netherlands it is only 25%. Spain stands in the middle at 40%. Unquoted (mainly mutually-owned) institutions make up roughly 20% of the UK banking sector. "The smaller the country, the bigger you have to be," points out Claire Gouzouli, a director of First Consulting. "In a large country like Germany you can be the biggest bank with just 10% market share. In other countries you might need 30% of the market to be considered a big bank."

And before banks in Europe set off on a wave of cross-border mergers, many will consider the mistakes of the past. Barclays' purchase of Merck Fink in Germany in 1990 has been a poor investment. Crédit Lyonnais went on an acquisition spree in the early 1990s acquiring, among others, Banco Jover in Spain, BfG in Germany and CL Nederland in Holland, a network which it is now dismantling. Other cross-border linkages and cross-shareholdings, such as that between Dresdner and Banque Nationale de Paris and the one between Royal Bank of Scotland and Banco Santander, have not delivered much value.

One lesson from these misadventures is that buying a small foreign bank whose franchise value will shrink over time - like Merk Fink - is pointless. If you are going to do it, you have to do it seriously and not just hope that something significant emerges from a few strategic cross-shareholdings and agreements allowing other bank cards through your ATMs. Of course, there is another lesson which could be drawn. Don't bother going abroad at all.

The most successful banks, such as Lloyds TSB, have eschewed foreign adventures. Chairman Brian Pitman grew Lloyds by concentrating on the UK retail market, achieving cost savings and revenue synergies from combining the up-scale Lloyds brand with the more blue-collar TSB and then adding the premier low-cost mortgage company, Cheltenham & Gloucester. It's the so-called multi-brand approach. Investment bankers have continued to pitch acquisitions in Europe such as CIC in France but Lloyds TSB has turned them down flat. The bank's credo appears to be summed up in the catch phrase of one of its senior executives: "Abroad is for holidays." This approach and ruthlessly disciplined management have earned Lloyds TSB a tremendous stock-market following and the biggest market capitalization of any bank in Europe: $70 billion at the start of this year.

Today, the pricing of similar banking services differs markedly from country to country, as do the returns. Profitability in retail banking is highest in the UK, explaining why banks such as Lloyds are happy to concentrate on their home market. If it were to make another acquisition soon, Lloyds would be more likely buy a former building society such as Woolwich or an insurance business than a French retail bank.

By contrast, German banks are keen to do anything to improve on the weak returns in their domestic banking business. Even investment banking looks attractive by comparison. It might make sense for a Dutch or German bank to try to break into the UK personal financial services market, but the high stock prices and high multiples of UK bank's put acquisitions out of their reach. More surprisingly, no large European bank has yet tried to enter the market through a direct channel such as telephone banking. "I'm not sure why," ponders Davis. "Are they waiting for the single currency, or greater acceptance for the internet?"

Banks are all pondering how the European market will evolve come the single currency. A bank might have a deposit-gathering business in one country of the euro block and use this to build an asset base by lending in another country. No bank today could risk such a huge currency mismatch. Technology might also open up access to customers in a business where few players have built strong brands and many still compete on price. "The combination of technology and more harmonized financial markets increases the potential for, say, a German bank to offer products to a Spanish customer using an advert in a Spanish newspaper for a toll-free number that is answered in a third country by the banks' Spanish-speaking team," says Chisholm. "Potentially enlarged access to customers will emerge for both traditional and non-traditional players. Banks are thinking about that both offensively and defensively."

Another theory is that the disparity between pricing of similar financial services in different countries will disappear and margins on services will average out. That means it would makes sense for a UK bank such as Lloyds to take advantage of its high share multiple to buy a cheap bank in a country such as France or Germany with low stock prices and thin profitability. Within a few years it could expect to see margins shrink in the UK and expand in France and Germany.

As theories go, it's a fair one. Persuading any bank to bet on it, let alone a highly disciplined bank like Lloyds, is a different matter. Although deals like MeritaNordbanken appear to point the way towards more cross-border deals, some bankers are not convinced. "You could say that MeritaNordbanken is more a regionally-focused cross-border transaction in the nordic area. A new type of cross-border deal would be a German bank buying in France, a Spanish bank in Germany, a Dutch bank in the UK, a UK bank in France," says Richard Boath, head of FIG at Salomon Smith Barney in London. "You can see how a pan-European bank might emerge. A French and a German merge then do a third deal with a UK bank. But even the first type of deal hasn't happened yet."

But perhaps some senior bankers are thinking along these lines. Rolf Breuer, head of Deutsche Bank, has spoken of the bank's desire to do something in France. ABN Amro has also taken a look at French bank CIC, which is in the process of being sold. ING has also mentioned plans to expand south from Belgium into France. Santander has talked about building a large bank in southern Europe. Chisholm predicts: "While the focus may remain on domestic consolidation in the near term, there will be an increasing amount of cross-border activity in contiguous markets where there may be natural economic ties or overlap and cultural similarities. In addition there is a chance that one or two very large cross-border deals could occur that might really surprise people. At some stage even a large trans-Atlantic transaction should not be excluded."

Special tourist price

If that process does ever start, each deal will be fraught with difficulty. A domestic acquirer will always be able to pay more for a bank than a foreigner because of the greater potential cost savings. So a big bank trying to plant its flag in pan-European retail banking might have to over-pay to beat off other domestic bidders. That would be hard to justify to its own shareholders. But the senior management of a bank under attack by a domestic competitor might happily seek a foreign white knight, hoping to survive as the local country managers for a foreign owner, rather than lose their jobs following an in-market cost-cutting deal. One FIG banker says: "You can bet that if Commerzbank is ever threatened by Deutsche or Dresdner, [chairman Martin] Kohlhaussen will be straight on the phone to Credit Suisse."

A bank that was big enough to afford to outbid domestic players for a sizeable foreign acquisition might succeed in justifying it to existing shareholders as a strategic necessity. "It's a question of who you want to be allied with in each country," says Brown at Morgan Stanley. "Some banks may think they have to make moves soon, because no bank has much chance of building organically in another country and taking on the local players."

Even if big banks do start buying or merging with each other across borders, it is unlikely that any single bank, Deutsche or ING or Lloyds, would ever quickly become a dominant European bank under a single brand name. "The successful European bank of the future may have several names. It could continue to be BBL in Belgium, NMB in the Netherlands," says Terry Eccles, joint global head of FIG at JP Morgan. "There would be no synergies from closing branches. But what there might be is synergies in everything behind the branch: one operating and processing system, one product-design group, one treasury." In the McKinsey-speak so beloved of the present generation of European bank chairmen: one platform.

It's an intriguing vision which raises more questions about the future model for banks. A lot of bank business is processing. Certainly for large companies which raise funds mainly through the capital markets, banks are mainly useful for payments processing. But it doesn't take a bank to do that. "Anyone can shuffle paper, as long as it's in a controlled process," says Brown. "Processing could be out-sourced, re-located to the cheapest location in an emerging market." Banks must distinguish themselves in two ways, through products and distribution. So instead of merging with a domestic banking competitor, or doing a cross-border deal, they could buy an insurance company.

The attraction of insurance to banks is now well established. Insurance is perceived to be a generally more profitable product than banking. In mature markets such as the UK, long-term savings - including life insurance which is now more a form of saving for old-age than a protection against the death of the family bread-winner - is a faster growing business than traditional banking. Banks have their own advantages over insurers: first, stronger distribution and greater market penetration through branch networks, and second, greater size and financial strength. Last year several bank/insurance company M&A deals took place including the link-up of Credit Suisse and Winterthur in Switzerland, that of SE-banken and Trygg Hansa in Sweden, and the merger of Bank of Ireland and New Ireland, while in 1996, Halifax bought Clerical & Medical in the UK.

In some cases, such deals may be more defensive and less value-creating than their proponents make out. The bank achieves size (if not scale), making it more difficult for a competitor to acquire and it buys a good earnings stream. But is there any synergy? Or is the combined institution now a conglomerate, that might one day be broken up again?

Many banks have set up and grown their own life insurance business - selling a new product to their existing customers. The latest step is simply to buy insurance companies, including their assets under management and their different types of sales forces which may include telesales, direct sales and independent financial advisers.

There are potential savings: there would be one asset-management team and one product-design team. "Buying a life insurer can give fresh impetus to a bank's in-house bankassurance business," adds Antony Hotson, managing director at SBC Warburg. But there are considerable cultural differences between a commission-driven insurance salesforce stuffing heavily front-loaded policies down the customers' throats and bank branches offering simpler, more transparent accounts to customers who trust them.

Separate committees

"There is a growing assumption of convergence between banking and insurance," notes Davis. "But groups like Fortis and ING which combine the two have committees of bankers and insurance people to run separate networks. No-one, to my knowledge, has yet succeeded in bashing together insurance and retail banking under one management." SE-banken and Credit Suisse may be the first to try.

In the meantime, the insurance industry itself is consolidating with plenty of in-market mergers of its own. Last year saw the mergers of Sun Life with Equity & Law and Prudential with Scottish Amicable. In 1996 Axa and UAP merged, as did Royal and Sun Alliance. Such mergers raise obstacles to bank acquirers which have previously benefited from their larger size and market capitalization. The prices for life-insurance companies with their own independent financial advisers are now high, especially following the Prudential/Scottish Amicable deal.

If the FIG groups cannot pitch an insurance acquisition, an in-market merger or a cross-border deal to their banking clients, they will have to be content advising them on how to allocate capital better, perhaps by divesting poor-return businesses such as investment banking. But in truth the FIG groups will be busy for years to come.

With many thousands of providers across the continent, banking remains one of Europe's largest and least consolidated industries. It's difficult even to imagine a banking industry reduced to a handful of leading names in the manner of the auto or pharmaceuticals businesses. Gouzouli says: "That would take at least 10 years. And that's not 10 years from now, but 10 years from when the last act of legal, tax and accounting harmonization is passed to create a truly single European market."