BARCELONA – The days when bankers could pay 3% interest on their customers’ deposits, lend at 6%, and make it to the golf course by 3 p.m. (the “3-6-3 rule”) are long gone. While some bankers remain oblivious to the looming threats to their business, the fact is that banks are now in dire straits, judging by their dismal valuations (in terms of price-to-book ratios) and low current and expected future profitability.
In the pre-pandemic world, low interest rates, fintech competitors, and rising regulatory compliance costs were among the greatest threats to the industry. Since the 2008-09 financial crisis, Europe’s banking industry, in particular, has been saddled with excess capacity and low profitability. And now, COVID-19 has made matters worse, eliminating any hope that interest rates will rise anytime soon.
According to Andrea Enria, the chair of the European Central Bank’s Supervisory Board, non-performing loans could reach €1.4 trillion ($1.7 trillion) in the eurozone as a result of the current crisis. Moreover, COVID-19 has accelerated the process of digitalization, which has put even more pressure on traditional banking. Customers and banks have discovered that they can operate remotely with ease, and this has made European bank branch networks appear even more overextended than they already did. They will need to be cut to size much sooner than anticipated.
Banks should be investing heavily in technology to shift their operations from the mainframe to the cloud, or else they will struggle to compete with fintech start-ups, let alone the Big Tech platforms that are making inroads into financial services. Cost reduction is now the name of the game.
In Europe, the most expedient way to cut costs is through domestic mergers that reduce overlaps in branch networks and consolidate the back office. Ideally, the resulting merged entity will be able to improve profitability and its capital position. This is the rationale behind the merger between Spain’s CaixaBank and the state-rescued Bankia.
But as CaixaBank’s past experience with absorbing failed savings banks shows, it takes a lot of managerial resources to achieve the hoped-for synergies after a merger. And, as the case of TSB and Banco Sabadell in the United Kingdom illustrates, information-technology integration can pose difficulties. Indeed, Sabadell entered into merger talks – unsuccessful so far – with BBVA.
Meanwhile, the talks between UBS and Credit Suisse have an important global dimension, because the two firms are trying to build an entity capable of competing with the US giants in wealth management and investment banking. Across the board, European corporations have come to depend increasingly on US banking behemoths like JPMorgan Chase, Bank of America, and Citibank, leaving European institutions farther behind. In fact, the eurozone’s five largest banks – BNP Paribas, Crédit Agricole, Santander, Société Générale, and Deutsche Bank – now have a combined valuation below that of JPMorgan alone.
As a result, European regulators, worried that banks’ low profitability may deplete their capital and lead them to take on too much risk, are looking favorably at bank consolidations. The ECB, for example, is willing to make allowances in terms of capital and the accounting treatment of badwill (the difference between the book value and the market value of an entity when the former is larger). It is also increasingly willing to permit mergers to result in banks that may be “too big to fail.” After all, the sector’s current configuration is not sustainable, and the alternative of letting troubled medium-sized banks fail is costlier.
Of course, European regulators would prefer cross-border mergers to domestic ones in the interest of fostering market integration and diversification and boosting European banks’ international competitiveness without raising antitrust concerns. Unlike in the United States, retail banking in the European Union remains unintegrated. If one looks at the dominant players within EU countries, one typically finds different domestic banks, whereas in the US the same large banks are present across many different states.
That said, there are larger obstacles to cross-border mergers in the EU, where one must navigate different languages and cultures. Although single bank supervision in the eurozone favors cross-border mergers, bankruptcy and consumer-protection rules are not homogenous across member countries, and a common European deposit-insurance scheme has yet to be established.
The political economy of the post-COVID-19 world will likely feature domestic consolidations in the short run, because governments will become more protective of national banking systems out of strategic political considerations. Indeed, banking nationalism has long been prevalent in Europe outside of the UK; and now Brexit will probably make cross-border mergers between British and EU-based banks more difficult.
Will the forthcoming era of consolidation hurt competition, by creating an anticompetitive market structure? Not necessarily. For competition not to fuel excessive risk taking, entities need to be able to generate and keep capital. Moreover, as long as new digital entrants face low barriers to entry, they can sustain the intensity of competition and have a disciplining effect on incumbents. For their part, regulators will need to ensure a level playing field as the sector restructures, and competition authorities will have to stay alert to potential risks in any region or market segment.
The global financial crisis did serious reputational damage to the European banking sector. Most likely, the financial intermediaries that come out ahead after the current crisis will be those that not only operate transparently and ethically, but that also strike a deal that serves their customers better.
Xavier Vives is Professor of Economics and Finance at IESE Business School and a former lead independent director of CaixaBank.