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How to deal with the surplus capital on their balance sheets has become a key challenge for many financial institutions.
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For some companies, not having enough capital is a constant source of headaches. However, the situation is quite different for many global banks, as they are now sitting on stock-piles of cash. HSBC chairman Sir John Bond brought the issue clearly into focus in August, with a warning that the world’s five biggest banks would use an expected $60 billion in surplus capital over the next two years to launch a price war and un-dercut their rivals.
Some analysts took his statement to mean banks would unleash a bidding war for acquisitions. With banks possibly tempted to soak up low-margin business, some analysts speculated they might be better served—as HSBC has already shown—by using surplus capital to fund acquisitions and consolidate capacity.
“That is a significant amount of capital to reinvest in the business against the background of the current market con-ditions,” Bond said after announcing HSBC’s record first-half 2004 profits of $9.37 billion—a 53% increase over the same period last year.He added,“It would be unwise to relax.” Indeed, after leading some high-profile acquisitions in recent years that have given it a global franchise, HSBC has since set its sights on China, where it already owns stakes in the Bank of Shanghai and Industrial Bank, reaching an agreement in principle in August to take a stake in Bank of Communications, the country’s fifth-largest lender.
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Sir John’s comments came as little sur-prise to many banking analysts, who say the bidding war is already under way, us-ing acquisitions as a way to invest surplus capital. “Banks have been in an acquisi-tion mode, and so what we’ll see is a continuation of a trend that’s already there,” says Tanya Azarchs, a bank credit rating analyst at Standard & Poor’s in New York. The world’s highest-rated banks have consistently generated earn-ings above their capital needs, for which they have had to make decisions as to how to best deploy them.
Banks Eye Foreign Markets
For Azarchs, a key question is whether cross-border acquisitions will become more prevalent. Some banks may feel there’s not much room for organic growth at home, particularly in the case of mature markets where the population may be overbanked and the economy may not be growing rapidly.The situation already led Spanish banks such as BSCH and BBVA to seek opportunities in the higher-growth markets of Latin America, where they have been on an acquisition blitz for the past decade.
The jury is still out as to whether US banks are at this stage.While some analysts say they will need to consider cross-border acquisitions for growth, oth-ers disagree and argue there are opportu-nities still to be had at home. “The US banking system is still highly fragmented, so I’m certain that consolidation will continue,” says one banking analyst who believes only Bank of America has hit the 10% cap on market share of total deposits after its acquisition of FleetBoston. Cross-border acquisitions by US banks over the next five years, he expects, will be limited to the usual suspects: Citigroup, JPMor-gan Chase and Bank of America.
Citigroup analysts estimate European banks will produce more than €80 bil-lion in surplus capital over the next three years.Their analysis is supported by coun-terparts at Deutsche Bank in London. “We expect that there will be significant levels of surplus capital generated in the UK bank sector in the period to 2007,” says a Deutsche report on UK and Irish banks released in late August.The report predicts Royal Bank of Scotland (RBS), Barclays and HBOS are set to be some of the UK’s most capital-generative banks. Of these, says Deutsche, RBS and HBOS are the most likely to use surplus capital for acquisitions, while Barclays will likely deploy a mix of acquisitions and share buybacks.
“The key issue is how these war chests of surplus capital will be used,” says the Deutsche report.“We believe that follow-ing organic growth, acquisitions are the preferred route to deploy surplus capital, followed by share buybacks and then in-creased dividend payments.”
Deutsche suggests UK banks will be looking inward, however, as the best deals may involve in-market M&A.The; bank’s data show 58% of investment by UK bank acquisitions has been in-market (followed by the US at 22%).While Eu-ropean banks earned an 8.8% return on investment on the €305 billion spent on acquisitions since 2000, UK banks, which accounted for 45% of the value invested, Deutsche says, produced a higher 10.5% average return on investment. Of the UK banks, RBS has the best track record, creating £7.6 billion of value through acquisitions.
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Canadian banks are facing excess capi-tal challenges of their own. “Canada’s largest financial services companies are facing the best kind of problem we could imagine them having—they have far too much capital sitting on their balance sheets,” notes a report by TD Newcrest, the equity division of Canada’s TD Secu-rities, which says virtually all of the coun-try’s larger domestic banks and life insur-ers own more than C$1 billion in excess capital.
Canadian banks amassed their surplus-es when the possibility of more in-market mergers (halted by government limits) and possible US acquisitions (slowed by lofty acquisition multiples)—for which they had accumulated these war chests— began to fade. Low demand for corporate and commercial loans amid the econom-ic slowdown was another contributor.