European Central Bank (ECB) Vice President Vitor Constancio believes that the implementation of the banking union could stimulate a wave of mergers and acquisitions (M&As).
Speaking at an event in Dublin on Monday 2 December 2013, Constancio suggested that weak profitability and excess capacity points to “large efficiency gains” that could be gained through greater concentration. The process of M&As will be driven primarily by the need to raise profitability and increase returns on assets. However, there may also be collateral effects of the change in the institutional environment that may favour that movement, according to Constancio.
Conditions are shaping up to make increased M&A activity more of a probability than a possibility in the medium term. The introduction of the banking union next year – the single supervisory mechanism (SSM) and the single resolution mechanism (SRM), together with additional measures to harmonise deposit guarantee schemes - should be enough to tilt the balance in its favour he believes.
Since the crisis, the European Union generally, and the Euro area in particular, has seen retrenchment along national lines. According to a recent stability report from the European Supervisory Authorities, banks in Western Europe have retrenched to their home markets since the crisis (despite the Vienna initiative). This trend has been driven mainly by banks’ revised business strategies – focusing on core businesses and reducing risk appetite – against the background of sustained high funding costs and the challenging macroeconomic environment. Banks’ total assets declined 12% from 2008 to 2013, with the overall leverage ratio decreasing from 144% in 2008 to 120% in 2013. This downwards trend (towards 100%) is expected to continue for some years to come. According to our analysis, Europe is likely to see the disposal of some €240 billion of “non-core” assets – more than 7 per cent of total banking assets – over the next seven years as banks continue to reduce the risk on their balance sheets.
At the same time, the market is changing.
The Euro area is arguably over-banked: there are a similar number of banks in the whole of the US as there are now in the Euro area. M&A activity in Europe has declined steadily in recent years with the overall value of deals falling fourfold to just €10 billion from 2008-2010, with cross-border deals the most affected. Fragmentation along national lines has increased with the crisis. Constancio noted that the Herfindahl-Hischman concentration indicator for Euro area banks now stands at the 690 level, well below the range of 1000 to 1600 of acceptable concentration.
Banks’ deleveraging opens up opportunities for further development of the capital markets –a deepening of both the corporate bond and the equity markets – and the securitisation markets, particularly with a view to financing small- and medium-sized enterprises (SMEs). Constancio, however, warns against ‘over-disintermediation’ as this creates volatility, saying ‘a balanced funding mix of banks and capital markets is best for financial stability’. He believes that this new environment supports the continuation of the European universal banking model, noting that many universal banks got back on their feet quicker than other firms following the crisis, and notes ‘radical separation of retail and investment banking function (..) would go too far’. But, clearly, the pure ‘banking’ piece of the competitive pie has shrunk, and will shrink further.
So the conditions are ripe for further concentration and the time is coming for banks to take stock and plot a course for the longer-term.
Preparations for banking union, notably the ECB’s comprehensive assessment of the Euro area’s largest and most systemic banks over the coming year, and the EBA’s stress tests of all EU banks next year, should alleviate market concerns, providing reliable information on the quality of banks and their assets.
Constancio expects the SSM to implement “the most advanced supervision of banks”. This means using all the “modern methods to be forward-looking and risk-based”, focusing on the viability of banks’ business models, the robustness of their balance sheets to shocks and the evolution of their liquidity and funding positions over time.
The SSM will confront head-on with the problems created by the heterogeneity in the way that banks calculate risk-weighted assets. Even though euro area banks have a healthy median Core Tier 1 capital ratio of above 12% of risk-weighted assets, investors still have concerns about their robustness due to lack of transparency on how they calibrate their internal risk models, as well as differences in how models are validated across jurisdictions. This will be addressed. The SSM should create more homogeneity by imposing common principles about methods and models' parameters in order to improve the reliability of banks’ internal model.
The creation of the single prudential rule book and accompanying single supervisory manual for Euro area banks during 2014 promises the lifting of the regulatory fog of the last few years, providing clarity, certainty and consistency for banks operating in Europe.
So add together too many banks, considerable headroom before acceptable concentration levels are breached, and a shrinking market, and Constancio’s prediction sounds more like a probability. It is a question of ‘when’. Give the SSM a year or so to bed down and then all the factors should really come together.
Regulatory changes in areas like reward may put the EU at a competitive disadvantage on the global stage. Regulating pay levels could mean that EU banks struggle to recruit the talent they need to grow their businesses.
More than 3,529 bankers in Europe earned at least 1 million euros in 2012, up 11% in 2011. According to the EBA’s data, total pay for these ‘high earners’ increased from 2012, but pay levels still haven’t recovered from 2010 levels (which wasn’t a bumper year by any stretch of the imagination).
In 2012, the total pot of variable pay stood at around 4 billion euros — down from 6.3 billion euros in 2010. Concomitantly, aggregate fixed pay has increased by 26% over the same time period.
According to the EBA’s data, the lion’s share of high earners (with pay > 1 million euros) were located in the UK (2,714) in 2012. Germany (212), France (177), Italy (109) and Spain (100) lag far behind, partly reflecting the UK’s dominant position as the EU’s largest financial market and a hub for global investment banking. Not only are the majority of high-earners located in the UK but UK banks have more work to do to align their variable and fixed pay structures, which currently stands at a 3.7:1 ratio. In Germany, which has the second-largest number of top-earning bankers, the ratio of variable to fixed pay is 2.1:1, only slightly above the upper proposed cap.
This gap presents problems for the UK as it attempts to compete for talent with other global financial centres that don’t have a cap, like New York, Hong Kong and Singapore.
The UK government is attempting to block implementation of the cap and has launched a legal challenge (on 25 September 2013) to the ECJ. It believes the cap will not work because:
The UK government claims that the cap will damage competitiveness and financial stability. It could end up saddling banks with higher salary bills, making it harder to reduce pay rates in future if profits fall.
Notwithstanding the challenge, the EBA is pressing ahead with implementing the new pay framework for high earners. It intends to publish technical standards on the new pay cap by the end of this year.