By Patricia Kowsmann and Margot Patrick 

The coronavirus pandemic has brought a sense of urgency to Europe's ailing banks to scale up or risk dying.

Around the region's capitals, banks are exploring mergers after a decade of weak returns. They are drawing plans on how they can face a prolonged era of low interest rates, a gloomy economic outlook and souring loans that are expected to rise as borrowers struggle to keep their jobs and businesses. Mergers are a way to combine balance sheets while taking out a large chunk of costs, including by closing duplicate branches and laying off staff.

In Switzerland, UBS Group AG has studied how it could absorb smaller rival Credit Suisse Group AG. In Spain, which has been severely hit by the pandemic, CaixaBank SA is buying Bankia SA to form Spain's largest domestic bank. Another lender, Banco de Sabadell SA, is also exploring its options, including a domestic merger, a person familiar with the situation said.

A Sabadell spokesman said the bank has a plan to remain independent but will study options that increase shareholder value.

Christian Sewing, chief executive of Deutsche Bank AG, which last year held merger talks with rival Commerzbank AG that failed, recently said his bank wants to be part of consolidation once it improves its profitability. Commerzbank itself -- also struggling to make money -- might still need to find a suitor.

Many of the conversations are happening internally and have yet to translate into deal talks or takeover offers. And most discussions at this stage are around domestic rather than cross-border deals, which offer less cost synergies and would require deeper government involvement to push through to completion.

Chatter about a wave of consolidation in Europe has been going on for a decade because many countries have a fragmented banking system with too many banks and returns on equity have been slim or nonexistent. Action was constrained by issues ranging from regulatory hurdles to fights over which management team would run a combined entity. Now, the feeling that something needs to be done and done soon has never been so strong, according to bank executives and outside advisers.

European banks' return on equity, a key metric of profitability, sank to 1.3% at the end of the first quarter from 5.7% at the end of 2019. Some European banks are struggling to even cover costs. In the U.S., banks thrived in a stronger economy for years, allowing them to spend on technology and build up capital without having to go to shareholders.

"We are in a moment of disruption," said Bankia Chairman José Ignacio Goirigolzarri. "And when there's disruption, we have to react to it."

Bankia and CaixaBank, which agreed on a deal two weeks after saying they were exploring a merger, said it was being driven by the pandemic and low profitability from persistently low interest rates.

Bankia nearly collapsed and had to be rescued in 2012 by the Spanish government, which retained a majority stake. Mr. Goirigolzarri said the combined entity would have roughly 25% of Spain's loans and deposits and shave some $900 million from annual costs. Spain has more bank branches per capita than almost any major economy, with around 55 per 100,000 people, according to World Bank data, almost double the figure in the U.S.

Other banks have also stepped up internal conversations, trying to figure out if they, too, should seek a combination, according to bank executives and outside advisers. Even the stronger banks with little appetite for mergers are expecting to get dragged into takeovers by governments eager to find a savior for their weaker banks. Others are considering how to position themselves if large cross-border mergers eventually begin.

"Mergers, right now, are a survival move," said an official at a Spanish bank. "You need to gain scale to face all the uncertainty that Covid has brought."

Switzerland's two dominant banks, UBS and Credit Suisse, have weathered the pandemic better than other large European lenders because of their focus on global wealth management and a relatively strong home economy. But the possibility of the two merging, the subject of perennial speculation, was studied again recently by UBS as a way to cut costs and stay competitive against U.S. and European rivals, according to people familiar with the bank.

Multiple hurdles would have to be cleared, and no talks between the banks are currently under way, the people said. Any deal would likely have to involve selling business units since Switzerland makes banks hold more capital if they get too big.

So far this year, European banks have posted relatively stable results, giving the impression they are weathering the severe economic contraction well. But that is mainly because governments are sustaining the economies by paying companies to keep people in their jobs and getting banks to give borrowers payment breaks on their loans. Once those programs are lifted, analysts expect a wave of defaults that could push weaker banks to the brink of collapse.

That is particularly true for countries more severely hit by the pandemic, including Spain and Italy, or whose governments don't have the money to support the economy, such as Greece. In turn, banks' depressed share prices make it hard for them to raise more capital from investors. The Stoxx Europe 600 Banks index is down close to 40% this year. European banks are trading at a fraction of their net worth, a sign investors doubt their ability to survive or achieve sufficient profitability. In contrast, U.S. banks are expected to bounce back more quickly from the pandemic.

"We expect the pain for European banks to really begin next year," said João Soares, a partner with Bain & Co.'s financial-services practice. "Until then, banks need to prepare for the storm."

The European Central Bank, which supervises the largest banks in the euro area, has recently issued a draft guide on how it plans to treat some of the common issues in mergers, in an attempt to boost banks' appetite for deals.

"Before the Covid crisis, the need to adjust costs, eliminate excess capacity, and restructure the banking sector was very important," Luis de Guindos, the ECB's vice president, told reporters recently. He said the pandemic stepped up those needs and called for banks to consolidate "quickly and urgently."

--Ben Dummett contributed to this article.

Write to Patricia Kowsmann at patricia.kowsmann@wsj.com and Margot Patrick at margot.patrick@wsj.com

 

(END) Dow Jones Newswires

September 20, 2020 06:14 ET (10:14 GMT)

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