Any moment now, bankers in Europe expect a wave of cross-border deals among its many universal banks.¹ But no such wave has come yet, and for good reason: because of differences among Europe’s national banking markets, regulations, and business cultures, banks would gain smaller synergies from cross-border mergers than from domestic ones. Conditions favoring greater cross-border synergies are beginning to emerge, but shareholders of some European banks are pressing so hard for growth that international mergers may occur before conditions are ideal.

The structure of Europe’s banking industry means that one or two mergers will quickly trigger many more. Banks are at risk for getting swept into inopportune deals. Which banks would make the best partners, and what should be their postmerger strategy? To help bank leaders decide, we have imagined what the European banking system might look like in ten or so years, when competitive conditions are more uniform. Europe, we believe, will have three types of banks, all much bigger and more specialized than most of its banks are today, as well as large regulated monopolies providing the necessary infrastructure, such as payment platforms and stock exchanges. A bank that decides now what type it aspires to become will have a better chance of steering its M&A strategy through the next few turbulent years.

The pressure to consolidate

Europe’s banking industry, consisting of some 15,000 institutions, remains unusually fragmented (Exhibit 1), though it has been consolidating on the domestic level for some time. Since 1996, Europe’s major banks and insurers have been involved in more than 60 mergers and acquisitions, each worth more than $1 billion. Three-quarters of this activity took place within national borders, the rest mainly among players in markets with close cultural ties: Belgium, the Netherlands, and Luxembourg, for example, and the Scandinavian countries. For three reasons, most observers now expect cross-border deals among banks that don’t have such links.

First, opportunities for domestic consolidation have been exhausted in several European markets. In the Benelux countries, Ireland, Spain, Sweden, and the United Kingdom, the banking market is already highly concen-trated, and some leading banks have reached the maximum market share permitted by antitrust regulations: in Ireland, for instance, the two largest banks manage 80 percent of all current accounts. The less concentrated markets of France, Germany, and Italy still have room for domestic consolidation, but few banks may be available, either because their shares aren’t quoted or their ownership structures favor continued independence. German savings banks, owned and operated by regional governments, aren’t available, for instance, and Italy’s banche popolari give all shareholders one vote each, making it difficult to create broad shareholder support for any effort to influence management in favor of moves to consolidate. Banks in these markets must look abroad to grow by acquisition.

Second, banks are under tremendous pressure to increase their profits. The share prices of Europe’s 25 largest banks suggest that their shareholders expect profits to rise by almost 10 percent annually during the next four years. But we estimate that the pool of profits available is likely to grow by only 5 to 6 percent a year, thus leaving an annual gap of 4 to 5 percent, or €90 billion ($82.8 billion), in all over these years. Cost-saving cross-border mergers seem to many banks a tempting way to fill that gap.

Last, financial markets appear to reward scale. The larger European financial institutions generally have higher relative valuations than do midsize institutions. But top banks must go on growing fast to stay in the top league: over the past five to six years, the market capitalization of the ten biggest players has increased, on average, by 20 to 30 percent a year. These pressures for growth have pushed many banks into merger talks. The large French bank Société Générale recently said that it was considering 12 European merger candidates. Other institutions—including Deutsche Bank—have been holding discussions with many potential European partners.

Why then has no big cross-border merger yet taken place? Mostly because the economic benefits of international deals are unlikely to be as high as those of their domestic counterparts. The net present value of synergies in domestic transactions might typically be worth 10 to 25 percent of the smaller party’s value, but our research suggests that synergies from cross-border mergers could rarely exceed 5 percent. Partners in a domestic merger generally have overlapping branch networks, so the merged bank can close several branches without losing many customers. It can also combine headquarters and IT systems. But in cross-border transactions, such opportunities are smaller as well as harder and more expensive to realize.

Synergies from a cross-border takeover would be too small to justify the premium that the acquiring bank would have to pay to the shareholders of the acquired one. The only deals that make financial sense are mergers between banks of roughly equal scale, for which no premium would have to be paid. But for deals of this sort, the potential financial gains have so far seemed too small to persuade both sides to cope with disruptive choices such as where the head office should be located and who should serve as chief executive. (These issues may sound minor, but they have scuppered otherwise feasible deals.)

Nonfinancial barriers too obstruct mergers. National regulators, for instance, have blocked or complicated several transactions for reasons other than concerns about competitive conditions. In 1999, to cite an example, the Bank of Italy prevented Banco Bilbao Vizcaya Argentaria (BBVA), a leading Spanish institution, from acquiring UniCredito Italiano, a large Italian one: it demanded a merger of equals—which was an impossibility given the gap between the market capitalization of the two companies. Large differences among countries in labor, management, and corporate-governance practices also complicate bank mergers; governance structures in some countries, for instance, give certain minority shareholders a controlling stake and thus the ability to block transactions.² Once a transaction has been realized, the practical difficulties of synthesizing areas such as labor law, financial-accounting standards, and tax legislation give middle managers threatened by mergers great scope to hinder the process.

Conditions for mergers are improving

Even so, the economic, regulatory, and cultural conditions for M&A among Europe’s major banks are improving by degrees. The incipient consolidation of the providers of infrastructure services that support banking, for example, will make a big difference to the numbers.

Take the consolidation of volumes at the level of the automated clearinghouses (ACHs) that execute payments. They are usually monopolies owned by consortia of national banks and operate in one country only. The account-numbering scheme of each house—how many digits to use, and in what pattern, to identify each bank, branch, and account—defines the IT system used by all banks in that country. The large French and British houses each execute several billion transactions a year and thus operate at efficient scale. But houses processing fewer of them, such as those in the Netherlands, with two billion transactions, and in Italy and Spain, with only one billion, have a stronger incentive to gain scale efficiencies by consolidating their volumes. To achieve these efficiencies, the parties in combined automated clearinghouses would have to merge their IT operations—a difficult hurdle, since they usually have different IT platforms. Nonetheless, any such transaction would make mergers between banks in the two countries concerned more viable, for the merged entities could move to a single IT platform, providing additional synergies.

The increasing harmonization of European banking regulations also bodes well for the economics of cross-border mergers. Today, if a bank acquires a foreign one, the merged bank’s subsidiaries in each country must report to the national regulators of both. These regulators often have different reporting requirements, which therefore call for two reporting systems. Progress is expected here as well.

This and similar changes will slowly push the synergies from cross-border mergers somewhat closer to the levels of domestic deals. Consolidation among banking-infrastructure providers could take five to ten years, however, and agreement among European regulators much longer. Unfortu-nately, most of the possible cross-border mergers will probably take place before these improvements in their value-creating prospects are complete.

The domino effect

Suppose that merger talks between a large European universal bank—we’ll call it Eurofin—and similar banks have been failing, partly because the apparent synergies were too low to motivate both sides to settle the practical details. Out of the blue, two other banks agree to a deal, forcing Eurofin to cross two potential partners off its list. How many are left and for how long? Put on the defensive, Eurofin must find a foreign partner now if it is to remain in Europe’s premier banking league.

If that scenario sounds far-fetched, consider how the investment-banking landscape has changed since 1997, when the insurer-cum-investment bank Travelers Group bought the independent investment bank Salomon Brothers. Because of the potential synergies, many corporate banks were then wondering if they too needed an investment bank. Travelers’ move pushed many of them into buying one. In both the United States and the United Kingdom, prices for investment banks soared. The number of independent investment banks in those markets has since decreased by two-thirds, and the cost and scope advantages conferred by scale have eluded institutions that didn’t achieve comparable synergies by consolidating.

We have analyzed the way similar deals might change the banking landscape of Europe. If 2 of its top 25 banks, each with several potential partners, contracted a cross-border merger of equals, followed in quick succession by another such merger formed by 2 more of the top 25,³ the number of mergers open to the remaining 21 would immediately fall by almost half. The decrease would be so large because once a bank with many potential partners merges with a similar bank, all of the potential partners must cross both institutions off their lists. (If the two deals involved US banks—not improbable—the remaining deal pool would be reduced somewhat less, though still by up to 40 percent.) These deals could trigger many more mergers, with banks driven by the fear of being left behind. Demand would push up the price of potential targets.

If merger mania grips the industry, bank leaders may lose sight of how they expect cross-border mergers to create value. In our view, competitive forces are likely to fashion quite a different European banking landscape once all of the economic, regulatory, and cultural obstacles inhibiting synergies from cross-border mergers no longer exist. The coming wave of international mergers will be a part of the transition toward such a landscape. Banks that wish to control their own destiny and be competitive must know what they aim to become in that pan-European endgame in order to plan the pattern of their domestic and international acquisitions and their divestitures of subscale and nonstrategic businesses over the next ten or so years.

A pan-European banking system

No one can foresee exactly which business models will emerge as winners from European consolidation. But banks that have a point of view about the likely future landscape will be better able to clarify their strategies, communicate with the capital markets, and sharpen the quality of their discussions with potential partners. With these ends in mind, we have developed a vision of an "ideal" European banking market from which the major cross-border regulatory and legal impediments have been removed. We first listed the businesses that banks carry on today—18 in all, excluding infrastructure services. Then we separated businesses with no synergies and grouped synergistic businesses together. We saw few synergies between retail distribution (using a huge infrastructure to distribute mass-market products) and the issuance and advisory activities of investment banking, for example, so these two were separated in our analysis. This exercise produced four groups of activities, representing the four types of enterprises that might emerge in a competitive, efficient banking environment. To estimate how many such institutions might flourish in a single consolidated European banking market, we then assessed the optimal scale and value for each type (Exhibit 2). We recognize, however, that not all players in the market will embody one of the four types of banks in this idealized picture: some will always successfully implement mixed strategies or niche operations.

Regional retail distributors

Regional retail distributors will offer individual customers and small companies a one-stop shop for a complete range of banking products—payments, investment funds, insurance, credit cards, and pension plans—and advice on which ones to buy. Because of scale efficiencies, these banks will source many of their products from third parties. A retail distributor would be unlikely to expand across borders, since it would gain no branch synergies and could achieve efficient scale in many domestic markets. Competition watchdogs will likely require a minimum number of banks in each country but far fewer than now exist in some markets: the ideal would be five to ten⁴ with a market value of €10 billion to €40 billion each. Clearly, this ideal implies a lot more domestic consolidation in most European markets.

Pan-European product specialists

Many banking products that the retail distributors sell will be developed by pan-European product specialists. Open, intense competition among the specialists will enable the retail distributors to compare the costs and performance of these products to find the best ones. Deregulation and scale effects mean that there will be far fewer sources for them than exist today: for each product, an eventual five to ten pan-European specialists, we estimate, with a market value of roughly €2 billion to €20 billion apiece.

European and global wholesale banks

European and global wholesale banks, serving large corporations and insti-tutional investors by providing customized corporate- and investment-

banking products, will offer financing to customers and use a broad range of in-house specialists to customize solutions for banking and financing problems. Wholesale banks will resemble institutions such as today’s Citigroup or JPMorgan Chase, except that they will have no retail customers and there will be fewer of them—three to five in Europe at most, with a market value of €60 billion to €200 billion each. This outlook suggests that intense domestic and cross-border consolidation among wholesale-banking businesses is on the way.

Pan-European service providers

Pan-European service providers will execute domestic and international payments, clear and settle transactions on financial exchanges, and run those exchanges.⁵ In place of the many national providers existing now, there will be a very small number of strictly regulated Europe-wide service providers, each large enough to capture all available economies of scale, with a value of €5 billion to €10 billion each. The transition will therefore entail both domestic and cross-border consolidation.

What’s next?

European banks currently conduct almost every banking business. Getting to a pan-European banking market will entail acquisitions (as aspiring specialists build scale) and disposals (as these banks shed businesses outside their specialties). The next three to five years will be particularly uncertain for banks while cross-border mergers take place. Bank leaders can deal with that uncertainty by choosing the type or types of banks they aspire to run in the European banking system of the future and by developing a clear understanding of their potential M&A partners. This exercise will help those leaders to evaluate their merger options now and to determine how fast and how far they need to move.

To see how this process might work, consider Eurofin’s options. The bank has a strong retail and corporate customer base at home. It distributes its own and third-party products and has advanced wholesale-banking skills. In ten years or so, it might therefore be a retail distributor, a specialist in one or more products, or a wholesale bank. Which alternative should Eurofin choose? First, the bank ought to rank its aspirations against the feasibility of achieving them. Eurofin may, for example, want to produce both mortgages and credit cards. Suppose, however, that its scale and expertise in credit cards were already strong, while its mortgage business would be unlikely to lead the market. In retail distribution, Eurofin’s infrastructure is near optimal scale for the region it serves. Its wholesale operations are not at pan-European scale but could plausibly hope to be given their current strengths. At this stage, then, all three options might be feasible, but the mortgage business should be earmarked for eventual disposal.

Eurofin’s management will maneuver in the medium term toward optimal scale and skill levels for each option. Ideally, management might prefer to buy discrete banking businesses fitting its favored specialties rather than to merge with an entire bank, but few single businesses are for sale—banks don’t want to shrink at the moment. So Eurofin might assemble a ranked list of potential cross-border merger partners with complementary wholesale-banking and product operations, meanwhile making additional domestic acquisitions to expand its distribution business. If the first cross-border choice merges with some other bank, Eurofin can move to the next poten-tial partner on its list.

The immediate outcome of Eurofin’s eventual merger with another universal bank will be a giant universal bank. Eurofin will therefore need to winnow the businesses it gains, disposing of subscale ventures and those outside its chosen specialties, possibly swapping them for specialties that it wishes to build. Deutsche Bank, for example, recently passed its subscale insurance business to Zurich Financial Services, an insurer, in exchange for that company’s asset-management operations, an area in which Deutsche Bank is strong. Although such swaps are tricky because each party must want a noncore business from the other, we expect several more to take place across borders.

Eurofin may at first succeed in building three types of banks, but the viability of each will fluctuate constantly, depending in part on the changing scale and performance of competing businesses. The corporate development team will constantly recalibrate its longer-term goals and its choice of M&A tactics in light of the relative market position of the bank’s businesses. Eventually, keeping all three types of banks under a single corporate umbrella will create diseconomies of scale. Before that happens, Eurofin will have "modularized" all of the businesses, separating their customers, operations, and distribution networks so that each may be spun off without disrupting the others. Universal cross-border giants that go on trying to be all things to all customers will ultimately deliver less shareholder value than the emerging, more competitive large-scale specialists. Banks that make their earliest cross-border deals with their potential specialties in mind are likely to do better in the long term than those that rush into the first available deal.