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Europe's Banking Regulator Paves the Way for Bank Mergers


Europe’s main banking regulator is trying to clear the path for mergers between the continent’s lenders as the belief grows that scale is the key to reviving the struggling sector, people familiar with the matter said.

The regulator—an arm of the European Central Bank that covers the largest eurozone banks—is making this softer stance toward potential tie-ups known privately, according to bankers, supervisors and analysts. Some of its officials have also publicly tackled the issue in recent speeches. It marks a departure for the regulator from its perceived stance of imposing prohibitively tough conditions on mergers.

The ECB showed an openness to work with two Spanish midsize banks, Liberbank SA and

Unicaja Banco SA,

during merger discussions last year, according to people familiar with the talks. The talks with the regulator revolved around whether any additional capital could be raised through the issuance of debt, rather than from shareholders, according to one of the people.

The regulator is also more open to giving some time for synergies from a merger to kick in—for example, accepting a smaller capital buffer during that period, according to one of the people familiar with the matter.

The loosening comes as the eurozone’s fragmented banking sector struggles to make money. Low interest rates—which are set up by the ECB’s own monetary-policy arm—continue to eat up banks’ margins on loans, hurting their profitability and making them largely unattractive for investors. Mergers have been long touted as a possible answer to the region’s banking woes. Part of the rationale for larger European lenders is they need scale to compete with U.S. rivals that have outperformed them on their own patch since the global financial crisis. European banks’ average return on equity is around 6%, almost half that of U.S. peers.

“Somewhere in the back of their minds, the ECB realizes that the negative rates environment is weighting on profitability of the banks, and they need to do something about it,” said

Jérôme Legras,

head of research at Axiom Alternative Investments.

To be sure, the ECB’s ability to foster deal making in Europe’s banking sector depends on the willingness of banks to join forces. Historically that has sometimes proved challenging because of disagreements between the companies over board makeup, executive leadership and shareholder structure of the proposed merged bank.

Some bankers are also skeptical about the extent to which the ECB is willing to be flexible and whether that will be enough to trigger mergers. An official at a large European lender said while it is true the ECB is looking to be helpful, “at the end of the day they are supervisors, and supervisors are by nature very risk-averse.”

But more openness toward mergers could prove a game changer for Europe’s banking system, and could trigger several midsize mergers, particularly in the oversize domestic markets, according to analysts. Germany has over 1,500 banks, followed by more than 500 in Italy, 400 in France and 200 in Spain. Big mergers between some of the region’s larger lenders have been discussed in recent years, most prominently talks between German lenders

Deutsche Bank AG

and

Commerzbank AG

, which broke down on the cost and complexity of pulling off a merger.

“I definitely think mergers will happen, likely from the second half of this year,” said Filippo Alloatti, an analyst at Hermes Investment Management, adding that high costs for digitalization in addition to the low-rate environment are putting too much pressure on banks and forcing the ECB to act.

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Key to the regulator’s flexibility is willingness to ease capital requirements for a merged entity, something that has stalled consolidation among banks because few are willing to ask shareholders to put in more money.

In the past, the ECB has taken a tough stance on the matter. In 2016, two years after the banking supervision arm was created, it imposed tough conditions for the merger of two midsize Italian banks—Banco Popolare SC and Banca Popolare di Milano Scarl. The lenders were told to shrink their board size, make additional write-downs of bad loans and raise €1 billion in fresh capital.

The managers of both lenders branded the requests as excessive and opposed them for weeks. But in the end they capitulated. “Facing a position [of the ECB] which left no alternative, we decided to meet the regulator’s requirements,” Banco Popolare’s CEO

Pier Francesco Saviotti

said at the time.

Since then, sizable merger activity among banks has been muted, with many bankers citing hurdles imposed by the regulator.

More recently, though, the ECB has struck a milder tone.

“I would like to dispel the perception that the ECB requires higher levels of capital from merged entities,”

Andrea Enria,

the head of the ECB’s banking arm, said in November.

“Our objective is to support, rather than discourage, the effective restructuring of the merged entities and ensure that the resulting business model is sustainable,” he added.

In a speech the same month,

Yves Mersch,

another ECB senior official, signaled the regulator could revisit its assessment criteria for mergers, including on the treatment of bad-loan levels for the combined bank.

“As a supervisor, we step up our scrutiny of merged entities, at least at the start of their life, as we recognize the operational risk challenges posed by merging complex structures. That should not lead to double-counting, though,” he said.

Write to Patricia Kowsmann at patricia.kowsmann@wsj.com, Giovanni Legorano at giovanni.legorano@wsj.com and Ben Dummett at ben.dummett@wsj.com

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