This article was featured in the Financial News on November 8, 2017.
The European banking sector is notoriously fragmented. Most leading banks in each national market have no material presence in other markets, and no single bank is among the top five in even three large European countries. Other industries are not similarly fragmented. In the automotive, pharmaceutical and telco industries, for example, pan-European players have emerged over the past few decades.
This fragmentation reduces the efficiency not only of European retail banking but of the capital markets. Capital that could cross borders within a bank must instead be transferred through external transactions, often flowing through London – pre-Brexit, at least. The access of small and medium sized businesses to capital is reduced and economic growth is slowed
This fragmentation is a source of frustration for regulators. Hoping that pan-European banking consolidation will help to integrate the single market, they have been calling for cross-border mergers for many years.
Despite these hopes and calls, it hasn’t happened. There has been no appreciable crossborder consolidation in banking. Nor do we think more is coming – at least not in the foreseeable future – for the simple reason that it isn’t in banks’ interest.
Those calling for cross-border bank consolidation are getting things the wrong way around.
In a recent analysis on the European banking sector, we found that historically, inorganic growth strategies have not improved returns. On average, banks that pursued mostly inorganic strategies, cross-border or in-market, achieved return on equity of 4% to 6% between 2009 and 2015, which is in line with the returns achieved by banks that followed mostly organic strategies.
Disparities among the best and worst performers within each group were also similar, with more being explained by the home market of the bank than any other factor. For example, in the Nordics and Germany, inorganic domestic-focused strategies delivered better results, whereas in Spain and the UK cross-border banks have shown better relative performance.
A reason for this disappointing performance is the difficulty of finding cross-border synergies. Between 2006 and 2016, only 45% of all significant cross-border deals delivered net positive synergies. And the cost reductions from cross-border deals were 70% smaller than the savings delivered by domestic deals. Indeed, some of the savings attributed to synergies could have been achieved without the merger, since comparable standalone banks achieved similar levels of efficiency.
Cross-border synergies have proven elusive, in part, because most European banks are already at scale, which limits the unit cost reductions that can be derived from increased size alone. By our estimates, only small European banks (with less than €50bn in assets) are subscale in several areas. And retail banks with a clear geographic or segment focus are at scale in all important activities once their assets exceed €150bn. In fact, increased size is often the problem with M&A deals. Acquirers too often underestimate diseconomies of scale and the cost of complexity.
Of course, synergies have sometimes been delivered. But, even then, much of their value was paid away to the sellers of the target, and they have not therefore delivered higher total shareholder returns for the acquirers.
Establishing a cross-border presence does have risk diversification benefits. Banks with a cross-border focus have been less likely to become distressed. Of the 30-plus banks that became distressed during the crisis, only two had followed an inorganic crossborder strategy. And the ECB’s comprehensive assessment found that, under the adverse scenario, capital destruction at banks following an inorganic cross-border strategy was 25% lower than the average for other banks. This diversification benefit is reflected in lower Betas for banks pursuing inorganic cross-border strategies. But it has not translated into better total shareholder returns.
It is not cross-border M&A that will create an integrated single market, but an integrated single market that will drive cross-border M&A.
Cross-border M&A would be more attractive if genuine cross-border banking were possible within Europe. But cross-border banking still faces regulatory barriers.
There has, of course, been a push for a unified banking market, with prudential harmonisation and a single rulebook. And the Capital Markets Union is due to come into force by 2019. However, the domestic enforcement of liquidity and capital requirements and the absence of a unified deposit insurance scheme create considerable domestic discretion and variation. Domestic authorities also retain substantial powers of “moral suasion” through levers over which they retain full control, such as conduct standards. So European banking regulation and supervision are far from integrated.
An even more important barrier is created by fundamental cultural differences. These differences are not restricted to language and local customs. More importantly, they include differences in civil and commercial law. The financial services industry is more dependent on legal constructs than any other. Most banking products, such as loans, deposits or mortgage-backed securities, are contracts. And their terms and conditions involve concepts defined by legislation and the decisions of courts: “collateral”, “insolvency” and so on.
Variation in the legal frameworks within which banking is conducted – and, especially, corporate and personal insolvency law and associated collateral enforcement regimes – is the primary barrier to the creation of pan-European products, business models and banks. Until the relevant parts of law are harmonised and we see “European mortgages”, “European SME loans” or “European Deposits” as homogeneous as UCITS funds, we will continue to have as many banking markets as there are different legal frameworks.
The idea of harmonising these legal frameworks should not be seen as outlandish; civil codes did precisely that for several European nation states in the 19 century. But it is a monumental undertaking and, despite some promising efforts currently under way (around insolvency, for example), it will not be achieved any time soon. This means that Europe will remain unready for cross-border M&A in banking. European banks will continue to integrate at the slow pace observed over the last decade.
In short, those calling for cross-border bank consolidation are getting things the wrong way around. It is not cross-border M&A that will create an integrated single market, but an integrated single market that will drive cross-border M&A. And that does not look likely any time soon.