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 ((900x2) + (400x2) = 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 season.
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.