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On Friday we learned that Caixabank and Bankia, the third and fifth largest Spanish banks by assets, respectively, are exploring a potential all share merger. There is not much detail to the reports at this stage beyond the fact that the process and due diligence have started, but the news is interesting for a couple of reasons.
The European banking sector’s main challenge is profitability, not credit quality.
In other words it is the equity story and not the bondholder story that is the problem. In many credit metrics the European (and global) banking sector as a whole has never been stronger than it is today. Capital ratios are more than twice what they were a decade ago, and banks have virtually unlimited access to liquidity provided by none other than the European Central Bank. On the asset side of the balance sheet, riskier business lines have been shrunk or closed down altogether and business models have been simplified. As a result, underlying earnings volatility is lower than what it used to be. For banks, more capital and safer assets mean a better credit profile.
Profitability though is a different story, and here the sector has suffered mainly due to margin contraction. The ECB has taken interest rates negative and kept them there for a number of years. As banks are unable (or unwilling) to pass negative rates on to their customers via deposits, and at the same time competition pushes mortgages and other rates down, this has resulted in a compression of net interest margin. Return on assets and return on equity both suffer as a consequence, as do price-to-book value multiples.
In this context, mergers and acquisitions are a good way of driving economies of scale; they can improve profitability and returns on equity. There are a number of countries in Europe where the banking sector remains very fragmented, and while a lot of work has been done in Spain with the mergers of multiple ‘cajas’ in the last few years, there is still scope for further consolidation. Countries like Germany or Italy are also prime candidates for these sorts of transactions to happen in the future. Greater scale makes it is easier for banks to drive cost efficiencies and improve their bottom line, which is of course a difficult task to achieve organically when growth has been sluggish, as has been the case in Europe post financial crisis.
Such transactions are likely to happen more often in Europe in the future. It is the equity story of Europe’s banks that has been weak, not the credit story, but for bondholders it is typically a good thing to see the market value of an issuer’s equity increasing. This kind of news is constructive for the sector all round.
By Felipe Villarroel, Partner and Portfolio Manager at TwentyFour Asset Management