Moving to the beat
Liquidity, as Chuck Prince noted in 2007, is the back-beat of banking.
“… as long as the music is playing,” Prince, then-CEO of Citi, said, “you’ve got to get up and dance. We’re still dancing,” he said, just before the global financial crisis (GFC) interrupted the party.
Over 13 years later, the liquidity-laden banking sector continues to bust moves, albeit against a fast-changing rhythm and an ominous, yet strangely familiar, tune.
Monetary authorities have reset the beat with ultra-low interest rates and by flattening the yield curve to a dull one-note bassline that threatens bank profitability out into the indefinite future. At the same time, anemic growth in pandemic-hit economies has slowed core-lending revenues while much of the banking sector requires significant spending to upgrade IT infrastructure.
And banks, especially in Europe, increasingly don’t want to face this music alone. As the table below highlights, taking on new dance partners comes has pros and cons but the current rhythm has put banks in the right mood for mergers.
Figure 1. Bank mergers: ups and downsides
Benefit of scale
Low revenue synergies in domestic M&A
Higher market share
Regulatory capital add-ons (but this might change)
Source: Federated Hermes as at September 2020. For illustrative purposes only.
Cost-cutting is the major drawcard for all parties in the latest round of European bank mergers. However, mid-tier banks who typically operate under spending constraints are also eyeing up deals with other institutions as a potential way of upgrading their IT systems, allowing them to digitise on equal terms with larger incumbents.
Furthermore, the European banking market still has some scope for consolidation. For example, the Herfindahl-Hirschman Index (HHI), a concentration ratio measuring the market share held by the first 20 firms, reveals that a surprising number of eligible European banks remain as potential dancing partners.
Figure 2. Concentration nations: Herfindhal-Hirschman Index
Source: “Structural indicators for the EU banking sector,” published by the European Central Bank in June 2019.
Note: The HHI is calculated by squaring the market share of each firm competing in the market and then summing the resulting numbers. For example, for a market consisting of four firms with shares of 30, 30, 20, and 20 percent, the HHI is 2,600 ((900×2) + (400×2) = 2,600). Source: US Department of Justice.
First on the floor: Italian bank takes the lead in 2020
On 17 February this year, just as sell-side analysts were quizzing the chief of Italian mid-sized bank UBI on domestic mid-cap consolidation trends over dinner in Mayfair, compatriot institution Intesa Sanpaolo was plotting the first move of the merger season1.
In a surprise twist, Intesa Sanpaolo offered €4.9bn for UBI in an all-share deal that would create the seventh-largest bank by assets (about €1.1tn) in the eurozone, bringing along roughly 3m retail, private banking and small-to-medium business clients.
UBI, one of the better-quality mid-cap Italian banks, was previously considered more likely to take the lead on any merger rather be on the receiving end of a dancing request. Intesa’s bid represents a 22% premium on the UBI valuation of close to €4bn, an offer that should appeal to the target bank’s institutional shareholders (about half of which are global fund managers).
Under the Intesa plan, based on some impressive due diligence work, the UBI merger would see a 6% earnings-per-share (EPS) accretion with €730m of synergies: the deal would result in 5,000 job cuts, carrying restructuring costs of €1.3bn pre-tax but creating realistic cost synergies of approximately 2.5x.
Intesa says the deal would also accelerate the improvement of the non-performing loan (NPL) ratio to 5% in 2021, compared to 6% in the existing UBI business plan.
The purchasing bank would fund the provisions and restructuring costs by generating €2bn of ‘badwill’ (see box). Possibly, the UBI takeover blueprint could apply to many Eurozone banks, which – on average – trade at about 0.55% of their book value.
While Intesa will use some excess capital in absorbing UBI, the bank has committed to maintaining a €0.20 dividend-per-share (DPS) this year, rising above that level in 2021, which will reassure income-focused equity investors.
Badwill boogie: three steps to capital creation
In a merger where the purchaser buys the target bank under its tangible book value (TBV), the residual price difference appears as ‘badwill’ – a quantity that can ‘create’ capital in the accounts of the unified entity.
Here’s how badwill banking plays out in practice:
- The target bank is, for example, currently trading at 0.4x TBV, or a 60% discount to its last reported TBV;
- Assuming the buyer of Y pays the current market value (of, say, €10.4bn) to acquire its entire capital base (€24.6bn) this creates a ‘badwill’ difference of €14.2bn;
- Upon execution of the deal, this €14.2bn difference could be recognised as a gain in the profit and loss accounts. The ‘badwill’ could, accounting-wise, accrue to the retained profits’ component of equity, and count towards tangible equity as well as common equity tier 1 capital.
From Spain to Switzerland: it takes two (or more) to tango
More than six months after Intesa Sanpaolo held sway in Italy, two larger Spanish banks also confirmed an all-shares merger was on the cards, following weeks of market rumours. Combined, CaixaBank and Bankia would emerge as the largest Spanish bank by a significant margin, as measured by local assets, if the deal goes ahead.
With total assets of about €660bn and loans of €365bn, a merged CaixaBank-Bankia entity would establish itself as a true Spanish national champion in the same class as Credit Agricole in France. The proposed banking marriage looks good on paper, bringing economies of scale (notably in optimising expenses) and boosting fee generation through a bancassurance strategy.
Commercially and politically a CaixaBank-Bankia merger also has plenty of legs. CaixaBank, for instance, has grown since the financial crisis via a series of M&A deals; and, for the Spanish government, the arrangement offers a neat solution to reducing its holding in Bankia (a stake that will fall to about 14% in the merged entity). As well, creating a bigger business could take the edge off the low-interest-rate blues holding back Spanish banks – Bankia is one of the most sensitive to this rates environment compared to larger peers.
Given the positive features, the merger is odds-on to proceed. Generally, M&A activity is a bullish signal for the banking sector (excluding resolution-led arrangements), especially for the Spanish market where most mergers have been driven by bank failures such as the 2017 Banco Popular deal.
Potentially, a successful CaixaBank-Bankia partnership might encourage other banks onto the dance-floor but in the near-term, political entanglements and valuation concerns could complicate merger action among Spanish-owned banks like TSB and BBVA.
In mid-September, just a week or so after news broke of the Spanish banking merger plans, the well-informed Inside Paradeplatz blog dropped the bombshell that Swiss giants UBS and Credit Suisse were toying with a closer relationship of some sort.
Inside Paradeplatz, usually a reliable gauge of Zurich financial gossip, said the proposal, expected to complete next year, would bring cost synergies in the order of 10-20%. According to the blog post, both the Swiss finance minister and financial regulator, FINMA, had been privy to the UBS-Credit Suisse merger talks.
Later the same day, however, further reports suggested the mooted merger was simply a UBS scenario-testing exercise with no formal negotiations under way – yet.
The rumoured deal has history: UBS and Credit Suisse had previously been linked as likely partners. But if there is substance to the Swiss banking mega-merger this time around, it would not follow the relatively simple pattern of a domestic eurozone bank pas de deux (à la CaixaBank and Bankia).
Unifying UBS and Credit Suisse would require more than rationalising back-office functions and closing a few branches. Instead, any such Swiss deal would be about creating scale across all aspects of the conjoined institution’s global operations, including: investment banking; wealth management; private banking; and, even – to a degree – Lombard lending.
The strategic rationale of pairing the two Swiss banking stalwarts would necessarily require a deep, well-thought out plan around each business unit and geography: more of a slow waltz than a flamenco.