From Decline to Dominance: The Revival of European Banking Profitability

 

In a dramatic reversal of fortunes, shares of Europe’s major banks surged by 20% in 2023, outpacing the broader market and signaling a new era of profitability and investor confidence in a sector once deemed unattractive.

In 2020, the European banking sector seemed mired in perpetual decline. Near-zero interest rates, stringent regulations, and lackluster economic growth had rendered many banks unprofitable and unattractive to investors. This sentiment was starkly highlighted when BBVA and Sabadell abandoned merger discussions, a move that underscored the bleak outlook for the industry. BBVA, a major Spanish bank, had seen its market value plummet to €26 billion, less than 40% of its 2007 peak. Sabadell fared even worse, with a valuation of €2 billion, a mere fifth of its book value. However, against all expectations, the narrative for European banks has dramatically shifted in recent years, presenting new opportunities and marking many institutions as ripe for takeover.

The tide began to turn in 2023, culminating in significant developments by early 2024. On May 6th, Sabadell rebuffed another merger approach from BBVA, which this time offered €12 billion. This rejection was not merely symbolic; it reflected the newfound confidence and improved market conditions for European banks. Shares in Europe's major banks have surged by 20% this year, significantly outperforming the broader market. This recovery is underpinned by a number of factors: improved capital ratios, a reduction in bad loans, and enhanced profitability driven by higher interest rates, which have persisted longer than anticipated.

The transformation in the fortunes of European banks was further exemplified by UniCredit, Italy's second-largest bank, which reported a quarterly profit of €2.6 billion on May 7th, a 24% increase year-on-year. UniCredit's shares have soared by 46% this year, highlighting the market's renewed optimism. On the same day, UBS, a Swiss banking giant, announced its return to profitability just a year after acquiring Credit Suisse, signaling robust operational turnaround.

The newfound profitability and stability of European banks have spurred a wave of acquisition interest. On May 9th, BBVA launched a hostile bid for Sabadell on the same terms previously rejected. This aggressive move is likely to inspire similar actions across the sector. The recent acquisition of Virgin Money by Nationwide for £2.9 billion in March has further fueled expectations of consolidation within the industry. Nicolas Véron, a financial-policy analyst, suggests that the renewed enthusiasm among investors may encourage bank executives to revive dormant merger plans, much like the deal-making surge seen in the mid-2000s.

Historical precedents also offer valuable insights. In January 2004, Emilio Botín, then-chairman of Santander, expressed skepticism about large cross-border deals. Yet by summer, Santander had acquired Abbey National, a British bank, triggering a merger wave that culminated in the 2007 acquisition of ABN AMRO by a consortium including Santander. While today's market dynamics differ, with a preference for domestic consolidation over cross-border takeovers, the fundamental drivers of mergers and acquisitions remain compelling.

The current landscape is shaped by several factors favoring domestic consolidation. The reappraisal of banking economics emphasizes the advantages of dominating a single market over sprawling international operations. Huw van Steenis of Oliver Wyman notes that controlling a local market is now seen as more attractive and sustainable. Furthermore, the people leading Europe's banks today tend to adopt more conservative and pragmatic approaches, focusing on steady growth rather than ambitious cross-border expansions.

One potential catalyst for more ambitious deal-making is progress on Europe's banking union. The absence of a fully integrated banking single market and a shared deposit-insurance scheme are significant barriers. Joachim Nagel, president of Germany's central bank, has advocated for a hybrid insurance model that supplements national deposit schemes at the European level. Although implementation remains uncertain, such reforms could pave the way for more integrated and competitive European banks, making cross-border mergers more feasible and attractive.

Despite these structural challenges, the improved financial health of many European banks makes them attractive targets for acquisition. Unrealized losses on long-dated assets, which become problematic during acquisitions due to accounting rules, have decreased significantly. For instance, analysts at Barclays noted that losses at Italian banks fell from 10% to 5% of their market value in 2023. This reduction in paper losses enhances the appeal of banks like Sabadell, Deutsche Bank, Commerzbank, and ABN AMRO as potential acquisition targets.

The potential for a rush of deals is heightened by the fear of missing out, a powerful motivator in financial markets. A successful bid for any of these banks could trigger a wave of mergers and acquisitions, as other institutions seek to capitalize on favorable market conditions. Additionally, foreign banks and private equity funds are likely to show interest, potentially forcing European banking executives to the negotiating table.

Simply put, the unexpected resurgence of European banks, driven by improved profitability, stronger capital positions, and higher interest rates, has transformed the sector's outlook. Banks that once seemed doomed to stagnation, such as BBVA and Sabadell, are now thriving. These institutions, previously unattractive to investors, have seen their fortunes reversed as shares in major European banks have surged, outpacing broader market gains. Higher interest rates have played a crucial role in this turnaround by widening the spread between what banks receive on loans and what they pay on deposits, enhancing their profitability. This positive shift has not only stabilized the banks but also made them appealing targets for mergers and acquisitions.

As the industry continues to evolve, the strategic maneuvers of Europe's banking giants will shape the future landscape, with potential ripple effects across global financial markets. The recent uptick in hostile takeovers and mergers, such as BBVA's renewed bid for Sabadell and Nationwide's acquisition of Virgin Money, indicates a growing momentum for consolidation. This wave of deal-making is likely to continue, driven by improved financial health and investor enthusiasm. Not only that, the progress on regulatory reforms, such as the European banking union and hybrid deposit-insurance models, could further integrate and strengthen the market, making cross-border mergers more viable. The actions and decisions of these major banks will not only influence the European financial sector but also have significant implications for the global economy, as foreign investors and institutions look to capitalize on these developments.