(Bloomberg Opinion) -- Europe desperately needs its banks to function better. Low profitability, decrepit technology and a new wave of loan losses threaten to hobble even the continent’s strongest lenders. Share prices are close to historic lows. In this environment, it’s tempting for those in better shape to snap up their cheaper rivals. But banking bosses should think carefully before empire building.
Europe’s political leaders are anxious to prop up their national finance champions, which once ranked among the global banking elite, and to weed out the weaklings. Bank loans finance more than 80% of corporate and household borrowings in the euro zone, compared to slightly more than half in the U.S. During a pandemic-induced recession, Europe cannot afford a lending malaise.
With no end in sight to the monetary easing that has crushed profit margins, a fragmented market with too many bank branches should be perfect for consolidation. Bad loans arising from Covid-19’s economic carnage will eat into already miserly returns for years. In the meantime, competition from fintech and big tech companies will intensify.
Unfortunately, while some mergers might shore up returns and improve bank resilience, scale hasn’t always helped European lenders. Analysis by Credit Suisse Group AG shows that return on equity — a measure of profitability — in 2019 was higher among smaller banks than larger ones.
The other problem with mergers is that most banks still need to get their own houses in order before landing someone else with their problems. Expenses remain stubbornly high throughout the industry and legacy technology needs replacing. It might be easier to tackle this ahead of the politically charged process of combining two companies.
Take the rumors of a possible combination between France’s BNP Paribas SA and smaller domestic rival Societe Generale SA. Analysts at Morgan Stanley say a merger would allow “material” cost cutting in the two banks’ domestic retail businesses and some savings in investment banking. The two firms could pay for the deal in part by selling assets such as SocGen’s Russian activities. A French domestic market share of about 20% shouldn’t unduly worry competition authorities.
However, the better-run, steadier BNP would have to take on the mammoth task of integrating another bank’s dated technology, while adding little desirable diversification and SocGen’s inferior balance sheet. When measured against its capital, SocGen is sitting on a bigger pile of complex, risky trades than the more conservative BNP.
To encourage these types of deal, regulators say lenders can make use of an accounting quirk known as “badwill,” or negative goodwill. This means the acquirer can book a profit gain from the difference between the target bank’s depressed market value and its book value. This inflates the merged bank’s capital and cuts the cost of a deal for shareholders, but it’s no panacea.
With valuations at historical lows, boosting capital through this accounting trick leaves the enlarged bank exposed to future impairments. If the books of the target turn out to be worse than assumed at purchase, and the value of the badwill is subsequently reduced, it would cut the merged lender’s capital. That would be one concern if Deutsche Bank AG bought Commerzbank AG, for example, according to Credit Suisse analysts. Commerzbank’s badwill could represent almost half of Deutsche Bank’s core capital, depending on the premium offered in a merger.
In fairness, some mergers make sense. The two biggest deals this year — Intesa Sanpaolo SpA’s takeover of UBI in Italy and Caixabank SA’s purchase of Bankia SA in Spain — rely in part on badwill and still have a strong financial rationale. There’s room for a few more smaller deals in Italy and Spain, while Germany’s fragmented market of state-backed and mutual lenders is ripe for an overhaul. Even a mooted combination between Swiss behemoths UBS Group AG and Credit Suisse would be worth considering given their complementary securities businesses and strong private banks.
And if Europe ever completes the integration of its banking industries and harmonization of its legal systems, allowing funds and liquidity to flow freely, some large cross-border deals will become compelling. In the meantime, European bank executives may want to prioritize calls from cost-cutting consultants over M&A-pitching bankers.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Elisa Martinuzzi is a Bloomberg Opinion columnist covering finance. She is a former managing editor for European finance at Bloomberg News.
©2020 Bloomberg L.P.