Paving the way for European banking consolidation

26/10/20

The ECB seems to be opening the door for cross-border consolidation from a European supervisory angle. On 1 July 2020, the ECB published a draft guide (for consultation) that aims to clarify the ECB’s supervisory approach to consolidation projects involving Euro area banks, and ultimately to stimulate bank consolidation throughout Europe. Anthony Kruizinga and Martijn de Haan, banking and capital markets specialists at PwC, welcome the ECB guide but also see some remaining challenges that need to be dealt with.

Objectives of the ECB guide

‘I hope the ECB guide will pave the way for an accelerated process towards a long-awaited European banking consolidation,’ says Kruizinga. ‘This is necessary in order to create stronger and more sustainable banks that will be able to compete with large US and Asian banks for the battle of the continental European market. Banks also need to achieve economies of scale and have adequate tools to address other new challenges, such as the digitalisation of the banking sector.’

The draft guide does not contain new regulations but clarifies the ECB’s supervisory approach used to assess the soundness of an acquisition or of a business combination within the current regulatory framework. For one, the ECB aims to enhance the predictability of its supervisory actions, reducing some elements of uncertainty that could prevent the feasibility of certain transactions. De Haan: ‘However, opening the door for cross-border consolidation from a European supervisory angle is a starting point that remains subject to case-by-case ad-hoc supervisory decisions. This still results in uncertainty around the outcome for parties wishing to merge or acquire.’

Supervisory expectations

To achieve its goal, the ECB has defined the evaluation process of proposed transactions and its supervisory expectations about the outcome of the consolidation project. Parties involved in consolidation projects will be encouraged to engage with the ECB early in the process. This will allow the ECB to give preliminary feedback on such projects. The ECB will make use of its supervisory tools in order to facilitate consolidation projects which improve the resilience of banks.

De Haan: ‘Consolidation projects must be based on a credible business and integration plan and must improve the sustainability of the business model and respect high standards of governance and risk management. The ECB guide provides some key indications on the supervisory approach to consolidation projects, but some more details on how the business model and the integration plan will be assessed to define the prudential requirements of the combined entity might be relevant. This will allow players to better design the deal from the very first stages.’

Three supervisory factors and key hurdles

Experience has shown that at least three supervisory factors can play a key role in determining the feasibility of a business combination. In the past these factors have had a partially discouraging effect on consolidation projects. The ECB guide touches on some critical elements that to a certain degree ease the existing hurdles.

1. Post-merger Pillar 2 capital requirements (P2R) and Pillar 2 guidance (P2G)

The ECB will not penalise credible integration plans with higher capital requirements. The starting point for capital will be the weighted average of the two banks’ Pillar 2 capital requirements and Pillar 2 guidance prior to consolidation. Post-merger prudential requirements might even be lower in case the business combination generates an effective improvement in the business model and in the risk profile of the combined entity. On the other hand, increase in capital requirements can be expected if the risk profile of the combined entity will not improve and if the transaction entails a high execution risk.

Yet, national regulators play an important role in facilitating cross-border transactions, especially the ‘home-country’ regulators. Ring-fencing of capital and liquidity within the home-country hampers the free flow of capital and liquidity across borders. Kruizinga: ‘The obligation to keep a minimum amount of capital or liquid assets locally, limits revenue and cost synergy potential that can eventually create stronger banks and therefore lower the risk, also from a local prudential supervisory perspective.’

Next to this change in supervisory approach, the finalisation of the European deposit insurance scheme is of paramount importance, as this will most likely take away the tendency of ring-fencing by national regulators.

2. Prudential treatment of ‘badwill’

The ECB will recognise the accounting value of badwill, i.e. negative goodwill, but expects it to be used by banks for risk reduction and value-added investments. The use of badwill shall increase the sustainability of the business model. The ability to recognise and use badwill as capital and to fund integration plans or reduce risk exposures might make consolidation cases far more attractive. De Haan: ‘But when it comes to badwill, some more information on how valuation issues not yet recognised in the accounting value might be identified and treated, would help to come to a smooth design and execution of the deal.’

3. Transitional arrangement for the use of internal models

The ECB will accept the temporary use of existing internal models, subject to a clear model mapping and a strong roll-out plan. This will ease some disincentive to consolidation cases involving banks using internal models.

Implications for banks approaching consolidation

The ECB guide provides several indications to banks approaching a consolidation process, from the identification of the opportunity to the post-deal phase.

In the Design phase, players focus on selecting a “target” or a business combination that can generate value creation through industrial synergies, ensuring post-deal sustainability and profitability, showing that the badwill generated will contribute to improve the sustainability of the business model and defining its allocation (e.g. increase provisioning and cover integration costs). The deal must be carefully designed, with a robust business and implementation plan, identifying key steps to align internal models where applicable. In this way, the dialogue with the ECB can be effectively started from the very beginning of the process.

In the Execution phase, an accurate due diligence process (when applicable) must be planned, and an accurate set of information must be provided to the ECB in order to allow a careful monitoring of the process.

In the Post-deal phase the advance of the implementation plan must be carefully monitored and any deviation promptly addressed and shared with the ECB. When applicable, a focus must be dedicated to the implementation of the internal models to the combined entity. Ensuring a proper governance from day one, including suitable management, proper control functions and a reliable board, will be important.