Thursday, April 26, 2007

When Banks Merge, Investors Tend to Lose

  
The Globe and Mail, Derek DeCloet, 26 April 2007

It's about 7,500 kilometres from Toronto to Edinburgh, but for Bank of Montreal chief Bill Downe, it might as well be 70 million. His counterpart at the Royal Bank of Scotland, Fred Goodwin, is operating on a whole different planet now.

The Scottish bank leads a group that yesterday bid $98.5-billion (U.S.) for the Dutch bank ABN Amro, topping an earlier offer by Barclays. This is the kind of deal you can get into only if you are one of the world's largest banks. RBS, at $126-billion in market value, qualifies; it's four times larger than BMO. Nine years ago, the two were the same size. You could look it up.

Nine years ago is also when every large Canadian bank, save TD, was essentially frozen in time, denied the right to merge with each other by the Liberal government of the day. The takeover war in Europe drives home the cost of that paralysis: It means ABN-owned LaSalle Bank will either end up with the RBS group or with Bank of America, Barclays' bidding partner. BMO, whose Harris Bank unit is an undersized competitor to LaSalle in the U.S. Midwest, couldn't even get inside the auction room for LaSalle.

If only Paul Martin had just let the big banks merge in '98; if only the Liberals, and now the Conservatives, weren't so obsessed with electioneering that they allowed the merger question to fester for nearly a decade without resolving it. Wouldn't it be nice to have a Canadian bank operating on a world scale, like RBS or Barclays or BofA?

Sure would be. Economic nationalists would love it. Investors - not so much.

Here's the dirty little secret behind mega-deals in the banking sector: They don't work. Or at least, they don't work very often. Size is helpful, but only to a point.

If you don't believe it, ask the shareholders of Citigroup, J.P. Morgan Chase, Bank of America, Wachovia, Wells Fargo, HSBC, UBS, Royal Bank of Scotland or Barclays. Each one is a member of the $100-billion club, except for Barclays, which is nearly there. How many do you think have been a better investment than BMO over the past five years?

The answer is none. Over a longer stretch, 10 years, BMO's performance still fares better than average. Its 14.5-per-cent annual return, including dividends, beats the tar out of J.P. Morgan Chase (7.9 per cent) or Wachovia (6.9) or HSBC (10.8). Bank of America's Ken Lewis is a deal junkie who stole the headlines by agreeing to pay $21-billion for LaSalle, should Barclays win ABN. But no Bank of Montreal owner would trade his shares for BofA's 10-per-cent returns. Citigroup is a total mess. (All return figures are for the period ended March 31.) Understand that we're not comparing these companies' returns to that of a premier Canadian bank, or even an average one. We're comparing them to BMO, probably the worst-managed (and worst-performing) big bank in the country over the past decade. BMO's problems are numerous, but the biggest one is cultural, and as the only large bank to lose two attempted mergers (Royal Bank of Canada in '98, Bank of Nova Scotia in '02), it has been more affected by merger paralysis than any of the others.

"This bank has never gotten beyond, 'I'm selling myself,' " says one BMO insider, speaking on condition of anonymity. "There's zombies walking around here [waiting for mergers]. They've been dead for 10 years and they're still on the payroll." That's a hint, but only a hint, of why BMO last year had the slowest profit growth, the slowest revenue growth (except for CIBC), and the lowest return on equity of the five largest Canadian banks. By most measures, BMO has shrunk from No. 3 to No. 5 since the late 1990s - yet it has still been a terrific investment.

There are a few conclusions to draw from this. It's pretty hard to screw up a Canadian bank. Monstrous financial institutions are harder to manage than you might think. But it's also true that merger paralysis has a flipside. Canada's banks, by virtue of their size, may be shut out of the bidding for a LaSalle or similar-sized U.S. banks, but so too have they been protected from most foreign intrusion. (The few foreigners who've tried haven't had much luck. Ten years after its launch in this country, ING Bank earned $72-million last year. BMO earns that much every 10 days.) Canadian bankers want to merge so they can cut costs, get bigger and start competing with groups like RBS and HSBC for assets - all while keeping their comfortable oligopoly at home. They want to have it both ways (who doesn't?). But it's hard to argue that their smallish size is really hurting them; not a single large domestic bank had a return on equity below 19 per cent last year.

How long would that last if they, like BofA's Mr. Lewis, were running around offering to pay 22 times earnings for mid-sized U.S. banks like LaSalle? Not long. When it comes to mega-deals, Canadian bankers can't play. And thank goodness for that.
;