Please find the latest market commentary from Jerry del Missier, CIO:

Year end results season is confirming that the European banking community has finally returned to rude financial health after its fifteen-year journey in the wilderness.  Capital numbers are solid, large capital repatriations to shareholders have been announced, and as expected, interest in M&A has been piqued.  That an appetite for acquisition has returned with the healthy finances is not surprising, and given the unsettled nature of the banking community it should be welcomed. While we’ve seen a steady stream of transactions in recent years, there is still tremendous scope for consolidation of the sector.

Most markets in Europe still have too many subscale banks that struggle to earn their cost of equity through the business cycle given the increased cost of regulatory compliance.  They also face competition from new entrants that eat into market share (private credit) or erode margins (payment platforms).  In the low growth European economy, improved profitability must come from greater efficiency and cost management and not top-line revenue expansion, given that we are at or near the peak of net interest margin (NIM) growth.  Therefore, the focus of management must remain on improving costs-income ratios and adding scale.  Acquisition should be an important tool in the execution of that strategy.  But in an environment when almost all players are flush with capital and the yield curve has once again become their friend, any immediate vulnerability has disappeared.  Acquisition will require a premium which means disciplined execution becomes critical.

That discipline starts with selection of target.  Up until now we have largely seen in-country deals which have been driven by scale and efficiency.  This is the right path to follow since common business lines are easier to integrate and cultures tend to be similar, which results in a quicker path to enhanced profitability.  Tangible financial results should be the sole justification, not some narrative about building a regional champion or cross-selling additional products through distribution channels.  A deviation from this standard significantly increases the risk of integration and the complexity of the new organization.  “One plus one” never equals three and co-heads rarely result in anything other than half the decisions for twice the cost.

During the long recovery it was easier to remain focused.  The overriding objectives were recapitalization and adoption of new regulatory norms, and shareholders had limited say in the governance of banks.  With the return to financial health and managements’ shifted focus away from cost and capital discipline, boards must ensure that this shift doesn’t result in costly strategic mistakes.  The track record of bank M&A outside of distressed situations is very spotty, with more failures than successes.  And in the absence of a clear regulatory and political framework cross-border deals should be avoided.  There are many advocates in the advisory community and the press, but as was seen with the mooted Unicredit bid for Commerzbank, cross border transactions can very quickly become a political football between two governments.

An opportunity to permanently transform the European banking system through improved strength and profitability was surely missed during the past fifteen years.  It’s true that there were several significant distractions during that time, such as the sovereign debt crisis, but given the intertwined nature of banking and sovereign debt that unfinished transformation will have to be addressed at some point sooner rather than later.  A continued failure to do so threatens the sustainable financial health of the whole Eurozone in the event of future crises.  If, at some stage in the future, fiscal matters are further integrated, then the concept of a banking union may become a reality, and we might have the catalyst for genuine regional consolidation.  In the meantime, the focus should be on creating strong entities at the national level that are resilient and capable of competing against new entrants to financial services.  Having missed the golden opportunity to drive this when it was keeping many players on life support, the ECB (and politicians) should not stand in the way of well-conceived and diligently structured transactions.  A robust economy in the future will require a banking system that’s fit for purpose.