Consolidation in European banking: great progress except in Germany

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1 January Consolidation in European banking: great progress except in Germany In recent years the banking sectors of most European countries have seen marked consolidation, with the number of banks down considerably as a result of mergers and takeovers. In Germany, too, the number of banks fell, by. But going by the number of banks in relation to population (bank density), there are still almost twice as many banks in Germany as on average in the EU (ex Germany). The picture is different when one looks at the number of branches. Between 199 and only two of the large European banking industries the UK and Germany pruned their branch networks. In Spain and Italy the number of branches increased appreciably. Looking at the number of branches in relation to population, it can be seen that the consolidation in earlier years brought branch density in Germany into line with the EU average in this is without the German post offices. The degree of concentration in a country s banking sector measured by the market share of the biggest banks often has a major influence on banks profitability. In highly concentrated markets the operations of the country s leading institutions are efficiently sized. In countries with low concentration even the largest banks are unable to achieve sufficient economies of scale. The market share of Germany s five biggest banks (the G5 concentration ratio, by total assets) comes to just, which is only half the European average (39). In all the other markets with the exception of Italy there are large, influential and profitable institutions that make for a substantially higher concentration ratio. Owing to the differing structures of the individual markets, profitability and efficiency vary greatly among European banks. Ranked by return on equity, British banks are clearly in the lead in a comparison of banks from the five biggest European countries (Germany, the UK, France, Spain and Italy). German banks have underperformed the European average for many years, and since the end of the 199s they have been right at the bottom of the league. On cost-income ratio as an indicator of bank efficiency, the UK again comes out best. In the early 199s German banks were still close to the average on both scores, but they have been unable to hold their position relative to the European competition. Generally speaking, the German banks have suffered from chronically weak efficiency and profitability, especially since the end of the 199s. German institutions were unable to take advantage of the boom of the late 199s to improve their results relative to those of banks in other European countries. German market: fragmentation of the banking landscape Almost half of the market in Germany has been dominated for decades by banks in special categories: the public-sector banks, with a market share of 3 (measured against the aggregate balance sheet total of all banks in Germany), and the credit cooperatives with a share of 1. In the market for traditional business with personal and corporate customers, the strategic orientation of the savings banks, Volksbanken and Raiffeisen banks puts them in the lead. Institutions which seek to maximise profits, such as the commercial banks, achieve a combined market share of only (the four big banks : 1). The savings banks and credit cooperatives domination of the domestic retail market Number of banks (1/3) DE FR IT UK ES Change in number of banks (199-1/3) UK FR DE IT ES Bank density () Banks/1, inhabitants UK ES IT EU ex DE Branch density () Branches/1, inhabitants UK FR EU ex DE FR DE.95 DE IT ES

2 January EU-Monitor was one of the reasons why the big banks put considerable resources into building up foreign business and investment banking operations with varying degrees of success. Competition in Germany suffers not only as a result of the still high bank numbers and density and low concentration: the constellation of the three categories of bank (commercial banks, credit cooperatives and public-sector banks) which is unique in the world also has a detrimental effect. Some institutions do not have the objective of maximising profits and are therefore able to charge quasi subsidised prices and rates. Nor are they subject to the full discipline of the markets, because their legal form precludes a takeover. In the early 19s the situation in other European countries was similar. But market and competition-oriented reforms made greater progress there: it was decided that the relevant institutions should be privatised and this was carried out quickly. Germany has so far failed to take similar steps. The three pillars or categories in the German banking sector have remained largely unchanged. The pillars are fenced off from each other, and within the pillars that do not seek to maximise profits there is no competition as each bank operates within a certain geographical region. Italian banks: resolute privatisation and large banks created by cross-category mergers Some Italian institutions operate as universal banks, but most concentrate strictly on traditional domestic banking business. The five biggest institutions Banca Intesa, UniCredito Italiano, Sanpaolo IMI, Capitalia and Montepaschi di Siena have only a relatively small share of the market (9). Owing to the restrictions imposed by Banca d Italia in its function as supervisory authority, further consolidation will mainly take place among smaller and medium-sized institutions, as the bigger banks are regarded as sufficiently large and influential despite the relatively low degree of concentration. State influence on the banking system has been considerably reduced. Under the Amato law of 199, savings banks were transformed into private-law entities. Foundations are now their main shareholders. By the foundations have to reduce their stakes to less than 5 of the respective bank s capital ( Ciampi law of 199). One major difference from the German savings-bank sector is that the private banks can acquire holdings in, or merge with, Italian savings banks owing to the legal form of the latter. This has been done frequently and successfully: the biggest and most profitable banks in the country have emerged from alliances between private-sector banks and savings banks. UniCredito was created by the merger of seven private banks and savings banks. Banca Intesa was the product of a merger of several private banks, savings banks and credit cooperatives. In Sanpaolo IMI bought the Cardine Finanziaria savings bank group. All in all, the structural changes have proved successful. Even though the Italian banks, taken together, turn in at best average results, the large banks in the country stand out as being both highly efficient and highly profitable. Spain: good bank results thanks to focus on traditional, domestic banking business and intense competition In Spain a number of waves of consolidation within the individual categories of bank have resulted in the emergence of several strong financial institutions. Banks concentrate primarily on business with personal and corporate customers, with a strong focus on the domestic Change in number of branches (199-) DE UK FR ES IT G5 concentration ratio DE IT UK Euroarea 7 FR 53 ES Net interest margin FR DE UK IT ES Average cost-income ratios of European banks (199-1) UK ES IT DE FR

3 January clientele. The two dominant big banks, Santander Central Hispano (SCH) and Banco Bilbao Vizcaya Argentaria (BBVA) also do business in Latin America. In addition, there are capital ties with banks in other European countries. Spanish savings banks are still subject to state control. There are rules on profit transfer and the appropriation of profits. Profit maximisation is not one of the savings banks objectives, but they are nonetheless very market and profitability oriented. Owing to their legal form, savings banks cannot be taken over by banks from another category. From this year, savings banks are permitted to issue non-voting shares an initial step towards greater flexibility in raising capital. This possibility has not yet been used. For the present, individual holdings of such shares are limited to 5 of the capital. This rule might be eased or lifted in the long term, though, which would give similarly flexible scope for alliances as in Italy. The large savings banks such as La Caixa or Caja Madrid compete intensively with SCH and BBVA. In the past several years the savings banks have been able to raise their market share by about percentage points (to ) at the expense of the big private-sector banks. One reason for this was the enlargement of their branch network: more than, branches were added over the last eight years. The Spanish banking market displays two noteworthy features: first, relatively high concentration and, second, quite market-oriented conditions among the savings banks themselves as they do not operate on a regional basis, nor are they backed by special state guarantees. France: state promotes formation of large universal banks At the beginning of the 19s the state held a dominant position in the French banking sector, with a market share of almost 9 in deposits and in loans. Extensive privatisation began in 19. The state withdrew from major banks, but was very much involved in designing a new banking landscape with strong national champions. The large French institutions operate as universal banks, engaging also in investment banking, though they are not among the world leaders in this field. The consolidation led to the creation of, for instance, BNP Paribas, which is the second largest Continental European bank in terms of market capitalisation (after UBS). When the French government sold the state s remaining stake in Crédit Lyonnais to Crédit Agricole, this cleared the way for the recent merger between Crédit Lyonnais and Crédit Agricole. The resultant big bank is now a leader in domestic retail banking with a market share of more than 5. The government also wants the post office to engage, through a subsidiary, in a wider range of banking business. Given the network of over 17, post offices, this would have major implications for the structure of the French banking market and lead to much stronger competition with the different categories of private-sector bank. In the late 199s the savings banks were turned into cooperatives, but their objectives are still the common well-being and they are still restricted to doing business in a certain region. Only three of the seven largest bank groups are fully listed companies (BNP Paribas, Société Générale and Dexia); others are cooperatives, though they also aim to make profits. In deposits business there are a number of strictly regulated products whose prices are set by the state. In times of falling interest rates this state regulation has narrowed the banks average interest margin. In recent years it has been the lowest of all major banking sectors worldwide (in 1 only.9; Germany 1., USA 3.3; 1-year average from 199: 1.7) which, however, seemed to be no obstacle to a high market capitalisation of listed banks. Change in cost-income ratio 199 vs DE FR ES UK IT Average ROE (199-1) FR IT DE ES UK Change in return on equity 199 vs DE ES IT FR UK Lowest interest margin of all major countries worldwide

4 January EU-Monitor United Kingdom: few providers in major fields of business and specialisation in domestic retail banking The UK is home to the most profitable banks in Europe. Within the British financial system a distinction was initially drawn between commercial banks and building societies. The latter specialised in mortgage and deposits business with retail customers and operated as cooperatives. From 19 the regulations on building societies were relaxed with the result that some of the building societies demutualised and enlarged their business to include the normal range of banking products. The reasons why British banks are so successful are the strict focus on domestic retail banking with personal and corporate customers and the high degree of concentration in this field. After several forays into investment banking, most banks reverted primarily to domestic business with personal and corporate customers, especially in retail banking, where earnings are generally relatively stable. This field is also particularly attractive owing to the structure of the British market, in which there are just a few providers. This leads to margins that are well above those of other countries banking sectors. The banks great success is fiercely criticised, however, by the British Competition Commission, which interprets it as a consequence of oligopoly market structures. According to the Commission, prices and profits are too high and do not accurately reflect the banks performance. This has led to repeated recommendations to the government that it issue direct regulations on prices and fees and prohibit certain practices of the banks. Some of these recommendations have already been followed, so for this reason and others margins are tending to shrink. Netherlands: financial conglomerates and Allfinanz companies with supranational orientation The Dutch banking system is today regarded as a prototype for successful financial conglomerates and Allfinanz (also known as bancassurance) companies that look beyond a very small, saturated home market. Until the late 19s Dutch institutions were prohibited from conducting banking and insurance activities at the same time. As soon as this restriction was lifted in 199, some of the large financial services companies set about creating large conglomerates combining both types of business. Today, the resultant Allfinanz groups ING and Fortis (Dutch-Belgian) dominate the Dutch market, along with ABN Amro Bank, and have expanded their business far beyond the national borders and even beyond Europe s borders. The number of savings banks has fallen drastically in the last few years: of the banks in operation in 199, only remained two years later owing to mergers between savings banks and acquisitions by larger conglomerates such as the Fortis Group. Besides the large institutions, there are over 3 cooperative banks. These are formally independent of each other, but in practice act as a single unit under the name Rabobank. As such they hold a leading position in, for example, mortgage bank business where they have a market share of around 5. The Dutch market is considered to be saturated and highly concentrated, so there is virtually no further scope for expansion within the country. Backed by a strong position in the domestic market, the banks have therefore expanded heavily abroad. All in all, the example of the Netherlands shows that Allfinanz is evidently not necessarily a bad thing. Broad diversification in business can be advantageous and stabilise earnings without reducing the efficiency of the banks. UK: banks very highly profitable and efficient Success comes from concentrating on domestic retail banking Netherlands: successful Allfinanz 7

5 January Switzerland: two banks predominate Unlike any of the Dutch banks, individual institutions in Switzerland also have world-class operations in investment banking. UBS is one example. Following the merger of UBS and SBC and numerous acquisitions it is today a global player in universal banking. UBS s very good results have earned it its current top position among the Continental European banks and a place among the ten largest financial groups worldwide, ranked in both cases by market capitalisation. Following acquisitions and restructurings, the CS Group, the second main banking group, took the Allfinanz route and engages in insurance business through its subsidiary Winterthur. The Swiss banking sector is also shaped by the private banks and cantonal banks. The private banks benefit from their traditional specialisation and competence in asset management and from Switzerland s still strict banking secrecy. The cantonal banks, which are public-sector institutions, have mainly regional importance and have for years earned only low returns. Scandinavia: privatisation and supranational consolidation The banking systems of the Scandinavian countries are very highly concentrated. The five leading institutions in each country have extremely high market shares, e.g. in Sweden, in Finland and in Denmark. In view of the relatively small size of the home markets in terms of population, banks from different countries have joined forces. The Nordea financial group, for example, was created through mergers between banks from Finland, Norway, Sweden, and Denmark. Nordea has captured sizeable shares of the banking market in all four countries ( in Finland, 5 in Denmark, in Sweden and 15 in Norway). In the past, the structure of the Nordic banking markets was very similar to that of the German market, being divided into the same categories of commercial bank, savings bank and credit cooperative. In the course of the last decade, though, it has changed greatly as a result of privatisations and strong consolidation both within and among the different categories of bank, including the savings bank and cooperative bank segments. One example of such cross-category alliances was the merger in 1997 of the Föreningsbanken cooperative and Sparbanken Sverige to form FöreningsSparbanken. After weathering the banking crisis in the early 199s, Nordic banks are again able to report very good profitability. Central and Eastern European countries: foreign banks dominate highly concentrated markets The banks in the Central and Eastern European countries (CEECs) have made considerable progress with privatisation and consolidation. While state-run banks still hold roughly one-quarter of the market in Poland, which is the most populous of the acceding countries, the privatisation of the major banks in other countries such as Hungary, the Czech Republic and Slovakia has been largely completed. The consolidation ensuing has resulted in concentration ratios in the large CEECs measured by the market share of the leading banks in a country that are considerably above the Western European average (39). In Hungary, for example, the five leading banks hold of the market, and the share of the three largest banks in Slovenia comes to 5, in Slovakia 55 and Bulgaria 3. The large financial institutions in the CEECs are often owned by foreign banks mainly Austrian, French, Italian or German so that the assets of foreign banks represent up to 95 of total bank assets, the percentage varying from country to country. The CEEC banking markets generally promise strong growth as a considerable proportion of the population is still undersupplied Switzerland: two big banks dominate the market Ranking of financial institutions by market capitalisation EUR bn Citigroup 1 AIG 19 HSBC 1 Bank of America 1 Wells Fargo 7 Royal Bank of Scotland JP Morgan Chase UBS 5 American Express 5 Morgan Stanley 7 Figures as of end of Q3 3 Scandinavia: banking sectors highly concentrated CEECs: also progress with privatisation and consolidation

6 January EU-Monitor with banking services. Owing to the very high degree of concentration and the large holdings of foreign banks, the market is already well consolidated and almost entirely divided up among the first movers, so further major acquisitions by Western European banks seem unlikely for the time being. As in Western Europe, banks in the CEEC pursue a great variety of strategies. They concentrate on individual products or fields of business. Citigroup, for example, focuses on credit card business in Hungary and Poland, while the Austrian Raiffeisen Zentralbank specialises in business with small and medium-sized enterprises and high net-worth private customers. KBC (Belgium), Erste Bank (Austria), UniCredito (Italy) and HVB (Germany) have become involved in retail business with personal and corporate customers by acquiring local commercial banks. As might be expected, business in the CEECs entails greater risks than business in, say, Western European countries. While loan default risks have decreased in recent years, the proportion of non-performing loans is still relatively high: for example, in Slovakia 11.5, the Czech Republic 11, Slovenia 5.5 (at Western European banks: approx..). This is one of the reasons why, for years, banks in the Czech Republic and Slovakia have on average registered negative returns and very poor efficiency ratios. In addition, the principle of legal certainty is not as firmly established as in Western European countries, one consequence being that it is not always possible to realise collateral in full. The relatively high risks open up the possibility of high returns, such as those achieved by Polish banks: between 1993 and 1 Polish banks averaged a return of 1.1 on equity and foreign-owned Polish banks surpassed this figure by a wide margin (ROE 1.5). Polish banks also operate highly efficiently, with an average cost-income ratio of 5.. It is clear, though, that the higher returns in the CEECs have to be seen as a risk premium, as is shown by the fact that the volatility of bank returns in the four largest acceding countries is almost four times as high as that of the banks in the five largest Western European countries (unweighted average in both cases). Caution needs to be observed when interpreting the comparative figures for the CEECs. Nonetheless, it can generally be said that, thanks to the progress with privatisation and consolidation, the banking sectors there seem to be more efficiently structured than those of some Western European countries, and this has led to very good results at banks in some countries. The banks have good prospects of being able to tap the market potential resulting from the still relatively low levels of market penetration. However, the data make it abundantly clear that besides opportunities there are still pronounced risks. It is therefore too early to give a definitive assessment of whether the present success will be sustainable. The future of Europe s banking markets: cross-border consolidation and a greater variety of bank strategies An analysis of the banking markets, particularly those in Western Europe, confirms that the privatisation of state-run banks and higher market concentration do indeed have a positive effect on banks profitability and efficiency. Systematic privatisation was a precondition for efficient consolidation, in that it allowed the greatest freedom in the selection of suitable partners for cooperation. There are no signs whatsoever that the general public or companies are undersupplied with bank services. In banking systems with low concentration, e.g. Germany, efforts should therefore be directed towards creating the conditions that are needed for further consolidation of the national banking market. Different bank strategies in CEECs Cost-income ratios of banks in G accession countries (1993-1) PL HU*) CZ SK*) *) HU: 9-1; SK 97-1 ROE of banks in G accession countries (1993-1) PL HU*) CZ SK*) *) HU: 9-1; SK Privatisation of state-run banks and high market concentration improve bank results 9

7 January So far, most alliances in the larger banking markets have been domestic because differences in language and culture, and the smaller synergy effects of combining banking operations in different countries were seen as obstacles to supranational consolidation. Following a number of waves of privatisation and consolidation, concentration has now reached relatively high levels in many European countries. This means that only cross-border consolidation can open up further growth potential in the relevant fields of business. It is generally doubtful whether sustainable, long-term success can be achieved by focusing solely on domestic business. A bank that pursues this strategy runs the risk of falling back relative to competitors that are growing, and of losing relative market capitalisation, thus forfeiting strategic flexibility. Consequently, crossborder mergers will most probably play a greater role in future, especially against the backdrop of increasing financial-market integration in the EU. Banking strategy along with market structures, a major determinant of a bank s success proves, on analysis, to be far from uniform throughout Europe. There are examples of successful universal banks in Germany and Switzerland; Allfinanz is conducted very profitably in the Netherlands, for instance; and the most profitable banks operate in the United Kingdom and Spain, focusing on business with personal and corporate customers. The currently very positive experience in this field is prompting more and more banks to concentrate on this type of business and reduce investment banking activity, which is increasingly being left to the most successful players from the USA and, in some cases, Europe. While traditional banking business is indeed highly successful at present in terms of profitability and efficiency, it can be seen at some banks that the combination of commercial and investment banking can have the effect of compensating risks and improving performance in terms of the risk-adjusted return. The same applies to bancassurance business. It therefore seems likely that the diversity of business models will at least be maintained for a while. This view is supported by the present trend towards splitting up the value chain in banking. Banks are reducing their very great production depth and specialising in individual segments of the chain (e.g. production, distribution, clearing and settlement) in order to enhance their efficiency and profitability. This adds a further dimension to bank strategies. In the past, the banks adopted a basic strategic orientation (differentiation, cost leadership, niche strategy) and decided on the breadth of their product range, which led to their classification as commercial banks, investment banks, universal banks or Allfinanz institutions. Now, there is also variety in terms of production depth, resulting in a wider range of options for banks. Initial examples of innovative business models can be found throughout Europe in the form of processing factories or pure-play distributing banks, and universal banks are more and more often outsourcing processes that were previously regarded as core activities. All in all, banks will therefore in future have more possibilities to generate greater profits if the strategic options are supported by appropriate market structures. These are created when private banks with efficiently sized operations are active in their markets. For Germany, the road to such market structures is still long. 1) Reinhard Lahusen, (reinhard.lahusen@db.com) So far, consolidation mainly domestic Different strategies lead to success 1) A more detailed version of this article will appear in this series in the first quarter of 1