European banks will be forced into mergers within the next two years, Philippe Bodereau tells finews.com. Pimco's banking specialist reveals his industry favorites and gauges prospects for Switzerland's banks. 

Mr Bordereau, banks have been through very stormy times. Is the turbulence now over?

Yes, I think so. It was a long storm of about ten years. US banks are in very good shape now, as the industry is fully restructured. They are very profitable again, the balance sheets look healthy and the capital ratios are the highest since the 1960s. Equity prices have returned to pre-crisis levels. Of course, returns on capital are lower than before, because of tighter capital regulations.

What about European banks?

It’s a different picture depending on each country. The sovereign debt crisis hit especially the periphery and in particular Spain, Ireland and Italy. They have still huge stocks of non-performing loans to manage. But it’s coming down pretty much everywhere. The Spanish and the Irish banks are doing better and Portugal and in Italy we reached a turning point this year with non-performing loans and recapitalisation of banks. The list of problematic institutions is becoming a shortlist compared to the last decade.

So everything is fine?

No, there are still challenges regarding profitability of European banks. The majority of them are still at three to five per cent return on equity, which is not a sustainable level.

What would be a long-term figure then?

You must make sure to have a plan that aims for eight to twelve per cent. But I think it is difficult for certain banks to get there in the current interest rate environment. The big catalyst will be a rise in interest rates like we have seen in the U.S. But Europe will not have that in the coming years – maybe by 2020 at the earliest. Margins are squeezed, spreads are very tight and volatility is low – all this hampers profitability of banks.

Will this accelerate consolidation?

Yes, but not in a massive way. There are two ways banks can consolidate: you see the first in domestic markets like Germany and Italy, which are still quite fragmented. Within the next two years, cross-border consolidation, which we have not seen for the past ten years, will begin. The reason was the sovereign debt crisis which caused European banks to withdraw back to their own territory. I think also that the acceptance of paneuropean banking champions is higher now.

You don’t have many firms which maintain a big paneuropean commercial and retail business. But I’m not sure if takeovers are the right way. M&A track records especially among banks are very poor. The critical success factor of buying a bank is to what extent you can cut costs. That normally means firing people. But in the majority of European countries it is difficult to discharge staff – so it’s not an obvious solution.

Another possibility is to focus on core activities and sell divisions like asset management or investment banking.

This has been a topic for as long as I have been an analyst. The arguments are quite simple: It is true that a pure wealth manager would command much higher valuation. So there is a case to be made that the sum of parts is higher then the value of the whole group.

In particular it is true that investment banking commands very low valuations in general. And investment banking also draws pretty significant discounts as well because it is viewed as dangerous, volatile and opaque.

How likely are asset management or investment banking sales?

Not very. There is a decent case for substantial synergies between wealth management and investment banking.

Some investors seem to have doubts.

I think there is potential. As a private client I would like to bank with a financial institution which is able to offer a wide range of services, from wealth management to asset management and investment banking.

The investment banking units of most European banks including the Swiss ones are strongly connected to the lending business. They get investment banking mandates because they are lending to those companies.

I think is very hard to split. Instead, banks would choose to sell their investment banking units – although I doubt that will actually happen. First, because the bids are very low and second, because some stand-alone investment banks are too small to survive.

What about European banks merging their respective investment banking units?

Partial listings of different units will highlight the value of the group, which tends to be hidden in the complexity of the bank’s structure. This is what Credit Suisse tried to do with bringing its Swiss unit to the stock exchange, but it failed. Santander is doing exactly this.

Is a partial listing a good idea?

It is a good way to bring more clarity in the group structure. If you do the sum of the parts equation, it will also show that many investment banking units are valued at zero or even negatively.

What are your favourite banks?

Cleary the U.S. banks. They are the winners, especially in investment banking, whereas the Europeans retreated. J.P. Morgan is probably number-one. In Europe I would say BNP Paribas or Santander.

What about the Swiss banks?

They are fine. Their strategy of refocusing on wealth management is perfectly reasonable. But Swiss banks are not very competitive in investment banking due to tighter regulations in Switzerland; capital requirements are very tough, more so than in the European Union and significantly more so than in the U.S.

Philippe Bodereau is a portfolio manager and global head of research for Pimco, where he leads coverage for financial services firms. Before joining the U.S.-based asset manager in 2004, Bodereau worked as a banking analyst for Société Générale in London and Paris, after beginning his banking career at J.P. Morgan. Bodereau graduated with a degree is finance from French business school EDHEC.