Bank mergers and acquisitions in the euro area: drivers and implications for bank performance

Prepared by Isabel Figueiras, Sándor Gardó, Maciej Grodzicki, Benjamin Klaus, Laura Lebastard, Barbara Meller and Wouter Wakker

Published as part of the Financial Stability Review, November 2021.

Bank mergers and acquisitions (M&As) have been subdued in the euro area since the global financial crisis. Most M&A activity has had a domestic focus and has involved smaller targets, with larger and sounder acquirers acting as consolidators. Consolidation seems on average to have had a moderately positive impact on the profitability of the banks involved, although high levels of variance reveal the presence of large execution and design risks amid low overall returns on capital in the banking sector. Improved post-transaction profitability can be linked to targets’ lower cost efficiency, liquidity and capitalisation. Cross-border M&A transactions have been concentrated within a few small groups of euro area countries, supported by prior financial links and geographical proximity. Such transactions tend to be followed by a stronger improvement in profitability than domestic mergers, although this effect has diminished since the global financial crisis.

1 Introduction

Bank mergers and acquisitions are often regarded as an option for reducing overcapacity and weak profitability in the euro area banking sector. The euro area banking market has become increasingly concentrated (see Chart B.1, panel a), and a third of its banking groups – mainly the smallest banks – have disappeared since the global financial crisis. Despite this, the sector continues to struggle with weak profitability and excess capacity, with too many undersized banks and a costly physical banking infrastructure.^[1] Some measures of bank efficiency lag behind those of other advanced economies too (see Chart B.1, panel b). The efficiency and stability of the banking system would benefit from further consolidation^[2] which – as several policymakers have noted – should be driven by market forces, with each proposed transaction assessed individually.^[3] Against this background, this special feature reviews recent trends in the consolidation of the euro area banking sector, examines the characteristics and drivers of bank M&A transactions, and analyses the impact of bank mergers and acquisitions on the performance of euro area banks.

2 Developments in the euro area

M&A activity slowed markedly in the euro area banking sector in the wake of the global financial crisis. In line with developments globally, the value of M&A transactions, proxied by the total assets of M&A targets, fell by about two-thirds between the pre-crisis decade and the period since 2008 (see Chart B.2, panel a). Large transactions have become particularly uncommon, while the drop in the total number of transactions has been less steep. It has also become more difficult to finalise M&A transactions in the aftermath of the global financial crisis. On average, one in three attempted transactions has ended without a deal in the post-crisis period, up from one in six in the pre-crisis decade (see Chart B.2, panel b). This highlights the difficulties euro area banks face in finding an attractive match in an increasingly challenging operating environment that is characterised by low interest rates, low returns on capital and the ongoing digital transformation of the financial industry. Only recently has bank M&A activity started to recover, although it remains below pre-crisis levels.

Larger institutions and banks with stronger fundamentals have played a dominant role as consolidators of the banking market. From the acquirer perspective, medium-sized and large institutions have accounted for around 60% of all bank M&As in the euro area (see Chart B.3, panel a), predominantly targeting smaller institutions. This may indicate that targets have been selected to complement the existing business model of the acquirer rather than to combine two institutions with similar balance sheet footprints. The preference for smaller banks might also reflect disincentives for increasing the size of large domestic institutions in the capital buffer framework. Moreover, most bank M&A deals since the global financial crisis have contained at least one bank perceived by investors to be stronger than the median bank. Around 15% of all deals (mostly domestic deals) seem to have involved weaker institutions to the extent that lower bank valuations and weaker bank profitability are indicative of less solid bank fundamentals.

Bank M&A activity in the euro area has mainly focused on transactions within national markets. Around 80% of all completed deals in the euro area have been domestic. Italy and Germany, which have two of the least concentrated banking sectors within the euro area, have witnessed the largest number of transactions, but very few of these have reached beyond national borders. Cross-border activity has been less frequent since the global financial crisis, comprising rather small deals involving mainly Belgian, French and Dutch banks (see Chart B.3, panel b).

3 Drivers of bank mergers

Studies have found that bank mergers and acquisitions follow diverse rationales and have no single dominant motivation. These studies, mostly focused on the 1990s and early 2000s, indicate that mergers often aim at improving profitability and efficiency. More profitable banks were more likely to bid for other, weaker banks, as M&A targets.^[4] This also held for cross-border mergers,^[5] which were moreover found to occur more frequently when countries were closely linked by a common language or trade, for instance.^[6] Banks also engaged in M&As to gain market share and market power, or to diversify revenues.^[7] European studies support most of these rationales, finding in particular that smaller and less efficient banks were more likely to be acquired.^[8]

Empirical analysis shows that cross-border bank M&A transactions in the euro area tend to follow existing financial links. A gravity model was used to evaluate the determinants of M&A transactions in Europe based on data covering 385 transactions over the period from 2014 to 2020.^[9] Stronger links through bilateral interbank loans and securities holdings are associated with a higher number of cross-border M&As (see Chart B.4, panel a). Banks also often tend to acquire targets in countries where they already have a physical presence through subsidiaries,^[10] while entry into new countries seems relatively less frequent (see Chart B.4, panel b).

Cross-border transactions are more likely to occur within clusters of euro area countries. An M&A compatibility index was constructed using a gravity equation which captures the impact of financial, trade, and cultural linkages on the frequency of bank M&As over the period from 2014 to 2020. It shows that mergers between banks operating in some core euro area countries, including Belgium, Germany, the Netherlands and Austria, are the most probable constellation. Consolidation is deemed likely within two further clusters: French banks are thought likely to engage with banks in neighbouring countries, and Spanish banks are seen as a good fit with their Portuguese peers (see Chart B.5, panel a). By contrast, banks operating in physically distant countries are not so suitable as merger partners. However, the actual frequency of cross-border mergers involving some country pairs seems to lie significantly below model-implied potential (see Chart B.5, panel b). This suggests that factors not captured by the compatibility index, such as the prominence of cooperative and savings banks in a given country, may impede M&A activity, in spite of the strong financial links already existing between the countries involved.

4 Impact on financial performance

While the aggregate effects of mergers on bank performance seem mixed in the literature, they are conditional on sound execution and strategic fit. US studies provide only partial support for M&A-driven improvements in bank profitability or efficiency.^[13] A similar picture is painted by many European studies. For example, an analysis of the period prior to the global financial crisis finds that M&A transactions had a moderate but positive impact on the profitability of the banks involved. It also underscores the role of strategic similarities which generate economies of scale as a success factor in bank M&As, while integration of dissimilar banks often proves costly.^[14] The positive impact of M&As also appears to be more pronounced when transactions are executed in a financial crisis,^[15] as distressed valuations may prove opportune to a well-positioned bidder. At the same time, other studies find that M&As have a slightly negative impact on profitability but a positive impact on cost efficiency. This is interpreted as a sign that cost savings are passed on to customers in a competitive banking market.^[16]

Bank profitability following cross-border mergers seems to differ from that following domestic mergers, depending on the timing of the transactions. Mergers completed in the late 1980s and early 1990s tended to generate no clear improvement in ROE, while later cross-border mergers seem to have delivered a superior performance than domestic mergers.^[17] Although poor bank performance following cross-border mergers is often a result of problems preceding the transactions, it may also reflect an excessively optimistic price, poor execution and an inability to change the strategic course of the target.^[18]

M&A transactions involving banks with weaker capital and liquidity positions and higher cost inefficiencies seem to yield higher post-merger profitability. Before the global financial crisis, ROE improved following about 51% of transactions, rising slightly to 57% after the global financial crisis, as investors became more selective about approving mergers. Mergers involving more cost-efficient banks tend to be less likely to generate improved profitability over a two-year horizon (see Chart B.6, panel a). This indicates that M&As may serve as a catalyst for cost synergies which may be absent from transactions between highly efficient banks. While the link between the capitalisation of M&A participants and merger success is less clear, in the case of profitability-enhancing deals the median capital ratio of the acquirer is higher than that of the target (see Chart B.6, panel b). Finally, M&A transactions involving banks with lower levels of liquidity appear to translate into positive profitability effects (see Chart B.6, panel c), suggesting that higher levels of bank liquidity may deter banks from exploiting business opportunities.

Econometric analysis suggests that on average M&As lead to an improvement in the profitability of the merged entity. Following the methodology applied by Beccalli and Frantz (see footnote 16), the findings indicate that M&A transactions were followed by a statistically significant increase in the ROE of the merged bank after two years, relative to the weighted average of the acquirer and target, and the effect is larger for cross-border mergers (see cross-border dummies reported in Table B.1). However, large variance within this effect indicates that the risk to an M&A’s success may be sizeable. The effect of cross-border mergers seems to have waned over time too.

Credit risk and funding structures seem relevant to explaining the improvement in bank profitability after a merger. A study of pre- and post-merger performance in the euro area before 2001 finds that domestic mergers performed better when participating banks were similar, as measured using a similarity index defined as the distance between normalised financial variables of the two banks. However, cross-border mergers enhanced profitability when banks followed diverse lending and credit risk strategies.^[19] When mergers over the last two decades are examined, stronger profitability improvements are found for transactions in which one of the sides is burdened by high levels of non-performing loans (see Table B.2). This may point towards acquirers having better capacity to manage credit risk. When two participating banks differ in terms of funding structure, and the acquirer is more reliant on deposit funding, then historically the performance of the combined bank was marginally weaker.

5 Conclusions

Bank M&As have recently shown signs of recovery in the euro area after more than a decade of subdued activity. Transactions have focused on consolidation within national borders, and cross-border transactions have remained limited. Larger institutions and banks with stronger fundamentals appear to have played a dominant role as consolidators of the banking market. Cross-border transactions are also likely to follow existing financial links and emerge within clusters of euro area countries.

The empirical results presented in this special feature imply that M&As may lift bank profitability. While they are not the only solution that would raise euro area bank profitability to levels sufficient to cover the cost of capital, M&As have the potential to substantially boost bank returns on equity. However, profitability outcomes vary greatly, underscoring the need to design and execute such transactions well and to assess proposed transactions on their own merit. At the same time, assessment of M&A transactions should also consider the systemic footprint of the combined entity. The room for improving profitability seems larger in cross-border transactions, as well as where participating banks are less cost efficient and targets are burdened by high levels of non-performing loans.

Completion of the banking union, which would address one of the key sources of financial fragmentation, could unlock the potential of cross-border M&A transactions. Although appealing from a profitability perspective, such transactions may be impeded by the limited financial integration of the euro area (see Box A). Analysis of the drivers of cross-border M&As reveals that the single European market remains disjointed, as transactions have been clustered within a few small groups of neighbouring countries. While the supervisory approach to bank mergers has been clarified by the ECB,^[20] further harmonisation of the regulatory and supervisory framework could help to overcome the fundamental drivers of fragmentation.