Do you think Intesa’s bid for UBI Banca, whether it ultimately succeeds or not, will set off a process of consolidation in Italy’s banking sector?

The process of consolidation in Italy is ongoing. Bank of Italy data shows that from 788 distinct institutions in 2009, the number of banks had fallen to 505 at the end of 2018. Most of the banks involved in mergers have been very small, and the process has gone largely unnoticed. When it comes to M&A among larger players, the Intesa bid may raise the sense of urgency for some banks, though it would also limit opportunities.

In the sense that if the deal is successful, it will create an entity with over 20% market share in key products in what is still a fragmented market. We believe this will raise the pressure to consolidate among second and third-tier banks. So far, however, it seems that UniCredit is set on a stand-alone strategy, and there are not a lot of names left out there.

In the former popolari space, there are BPM and BPER, but the latter has already agreed to take over between 400 and 500 branches from Intesa if the UBI deal goes through and would be unlikely to get involved in another transaction soon. Credem has in the past sounded more open to potential external growth but would probably be more interested in smaller-size deals.

Could the Italian government use any consolidation wave to accelerate the rehabilitation and offload of problems banks, such as Banca MPS, Banca Carige or BP Bari?

It is a possibility of course, though not the most likely. As things stand, we believe that there is still a degree of uncertainty about the ultimate loss content of balance sheets and this may prevent deals. What Intesa’s bid shows is that in these days of heightened supervisory attention on asset quality, a credible balance sheet clean-up is a pre-requisite to enter M&A talks. This view is supported by the recent experience of Banca Popolare di Sondrio, which did not receive regulatory approvals in its attempts to purchase two relatively small institutions (Farbanca and Cassa di Risparmio di Cento) even though it had excess capital to requirements.

What are the main drivers of banking consolidation in Italy?

European supervisors have been pushing for some time for more consolidation in the European banking sector as a way to improve efficiency and profitability. Italy, alongside Germany, is one of the least concentrated sectors in Europe, with several micro, small and mid-sized banks. However it would be a mistake to think that supervisory pressure is the main driver for consolidation.

In our view there are two key drivers. One is lacklustre profitability and a lacklustre profitability outlook for many mid-size banks in Italy (and across Europe for that matter). The combination of a flat yield curve and the need to carry larger capital bases in the post-crisis regulatory environment means that many banks are continuously destroying value for shareholders. Consolidation can be a way of boosting profitability.

In addition, with customer behaviour changing rapidly, banks face the need for large IT investments. Being sub-scale may not be an immediate credit concern, but longer term it may lead to under-investment and ultimately underperformance.

Will consolidation in and of itself – particularly among second-tier banks – have a material impact on factors such as profitability, costs, headcount, branch concentration, and IT/digital spend?

I expect the number of branches, headcount and physical distribution costs to go down regardless of whether banks engage in M&A. This is simply accommodating the declining need for physical interactions with customers, and it is a process that has already been happening for some years. M&A could be a way to speed up such a process compared to stand-alone plans, though probably not materially. Where consolidation could have a larger impact is on central costs, on duplicated product factories, on the cost of regulatory compliance, and on funding costs. It would also support the banks’ stand-alone capacity to invest in digitalisation.

However, it is worth pointing out that the history of European banking is littered with M&A deals that turned out to be awful for shareholders of acquiring banks. M&A comes with risks, among them the risk of over-estimating cost synergies compared to stand-alone cost cutting, the potential for cross selling and revenue synergies; under-estimating integration costs, or the extent of revenue cannibalisation with regard to existing clients.

From a credit perspective, the biggest risk is that integration is not smooth and ends up taking up a larger share of management time and energy than anticipated. This could result in all sorts of problems, possibly more damaging to the bank in the medium to long term than the economic, quantifiable estimation errors just mentioned.

Is there any alternative? Or are we headed towards a world of a handful of megabanks in Europe?

I do think there are alternatives. If we look around the world, there are a number of countries where local community banks have managed to survive. However, they typically operate very simple retail-oriented business models. This is the case of Norwegian savings banks, or community banks in the US. Italian co-operative banks also fall into this category. At present, this model is threatened by product commoditisation and technology. I believe that for the model to be successful in the medium term, local banks will have to tighten up their alliances, and step up joint efforts in areas such as IT procurement and development.