See page 23 for Analyst Certification and Important Disclosures

Industry Report

E Q U I T Y

R E S E A R C H :

E U R O P E

Banks
19 January 2005

Europe
Riccardo Rovere
+39-02-8648-4715
riccardo.rovere@citigroup.com
Milan
Italian Banks
M&A — Not Plain Sailing?
Azzurra Guelfi*
+44-20-7986-4174
azzurra.guelfi@citigroup.com ➤ We identify some features that may make
London
Italian domestic consolidation more difficult
European Banking Team than generally thought
Albert Coll
Ronit Ghose ➤ First, in terms of asset concentration, the
Yann Goffinet* banking sector in Italy does not appear to be
Azzurra Guelfi*
Simon Nellis more fragmented than in France or the UK
Tom Rayner
Philip Richards ➤ Second, we see a limited number of banks as
Fred Rizzo*
Riccardo Rovere candidates for acquisition by the largest groups
Simon Samuels or creating sizeable entities in any consolidation
Jeremy Sigee
Kiri Vijayarajah
➤ Third, this scarcity factor may drive target bank
share prices up, but potential acquirers may not
*US Investors please contact one
of the other analysts listed be willing to pay hefty premiums for uncertain
revenue and cost synergies

➤ Fourth, the recent past shows us that, in many

cases, revenue synergies can prove illusory,
given their dependence upon macroeconomics

➤ Fifth, on the cost side, ultimately headcount

reductions drive cost savings, but further cuts
may be now more problematic

Smith Barney is a division of Citigroup Global Markets Inc. (the "Firm"), which does and seeks to do business with companies covered in its
research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this
report. Investors should consider this report as only a single factor in making their investment decision.
Italian Banks – 19 January 2005

Table of Contents

Investment Summary 3

Italy Not Such a Fragmented Market 4

Myriad of players in a concentrated market......................................................................................... 4
Italian banks and foreign ownership .................................................................................................... 5

A Brief History of Domestic Deals 7

The rationale for past domestic deals................................................................................................... 7
Cost savings targeted in mergers and acquisitions............................................................................... 9

Efficiency Improvements in 2002-03 12

Efficiency improvement achieved by standalone plans ..................................................................... 12
The cost control efforts of 2001-03.................................................................................................... 14

Obstacles to Domestic Consolidation 15

Popolari banks excluded from the game ............................................................................................ 15
Limited number of sizeable private sector banks............................................................................... 16
Industrial overlap within major groups .............................................................................................. 17
Geographical overlap within major groups........................................................................................ 18
Limited flexibility on headcount reduction........................................................................................ 19
Limited flexibility on staff reassignment ........................................................................................... 22
Conclusion ......................................................................................................................................... 22

2
Italian Banks – 19 January 2005

Why did Sanpaolo IMI talk to Dexia, a potential partner with

Investment Summary
which the market saw limited industrial fit? Why has the press
speculated about the possible interest of Unicredito in HVB1?
Why does domestic Italian M&A activity seems to be stalling
among the large banks? One answer may be that domestic
consolidation is not an easy game and many conditions have
to be fulfilled to make a deal compelling. The purpose of this
report is not to assert that domestic M&A activity will not
occur, but to list features that may result in obstacles to further
consolidation and, in the event of consolidation, may prevent
Italian banks from achieving significant synergies.
Limited number of players
The number of domestic Italian banks is still considerable, but, if we exclude
popolari (cooperative) banks, there are few medium-sized banks that might be
considered targets for the larger domestic banking groups. This scarcity might be
beneficial for the target banks’ share prices, but potential acquirers may not be
willing to pay hefty premiums for revenue synergies that are not easy to achieve
(as demonstrated over the past few years) and cost synergies highly dependent
upon further (in our view limited) room to reduce headcount, and upon IT
integration, in which Italian banks have invested and are still investing heavily.
We question whether it is correct to value potential target banks well above their
fundamentals in the hope that other players will bid for them. Ultimately, high
premium can only be justified by the achievement of synergies that have, in the
past, proven to be illusory (particularly revenue synergies due to a weaker
macroeconomic scenario). The strategy of investing in the shares of potential
target banks brings with it the risk that they simply stay independent.
Limited business and geographical fit
Any integration between the largest groups would involve organisations with
thousands of branches and tens of thousands of employees. For example, the
creation of Banca Intesa illustrates how painful an integration of big banks could
be (four years to achieve IT integration, branch network disposal and closing
down). Today’s larger domestic groups are bigger than Banca Intesa and Comit
were in 1999, and these problems might be magnified. Second, antitrust issues
in deposit/loans in northern Italy (the wealthiest region) and in asset management
generally cannot be ruled out. Third, given similar businesses mixes, we find
that, in most cases, revenue synergy generation (to which we would attach high
execution risk) would come from transfers of best practice, in the absence of
diversification.
Limited room for cost reduction
History teaches us that headcount and IT integration are the areas where most
of the cost synergies have arisen. At present we see this potential has dwindled.
After recent interventions on headcount and pension reforms, further sizeable
reduction programmes look more difficult to achieve in the short term. We
believe it might be some time before banks can obtain decent synergies from
headcount reduction. In addition, we wonder whether Italian banks would be
ready to incur significant write-offs on IT platforms (which would be changed
again in the event of M&A), after having already heavily invested in it. Possible
local franchise disruption, coupled with limited potential on cost savings and the
uncertainty of achieving revenue synergies, means integration problems might
outweigh the benefits.

1
Reuters - 09:55 10 Jan 2005: HVB stock gains on talk of Unicredito bid.

3
Italian Banks – 19 January 2005

Italy Not Such a Fragmented Market

➤ The number of domestic banks has dramatically reduced over the
past 10 years

➤ The size of the largest banking groups has almost trebled, and the
share of the largest five banking groups’ assets as a proportion of
total domestic assets has risen from 41% to 55%

➤ The number of banks remains considerable, but, in spite of the

increased concentration, the banking sector in Italy does not seem
to be more fragmented than in France or the UK

➤ The role of foreign financial institutions is unlikely to increase, as

we see no reason why the Bank of Italy’s unreceptive mood on this
should change in the short term

Myriad of players in a concentrated market

According to Associazione Bancaria Italiana (ABI)2, the number of banks operating
in Italy dropped from 1,069 in 1980 to 814 in 2002, including Banche di Credito
Cooperativo (saving banks offering products constructed by a central institute).
Figure 1. Italy — Decline in the Number of Domestic Banks, 1990 - Figure 2. Italy — Number of Mergers and Acquisitions of Majority
2002 Stakes, 1990 - 2002
1,200 1,156 80
1,108
1,100 1,073
1,037 70
1,000 994 970 66 64
937 935 921
900 876 60 58
841 830 56
814 52
800 50
50
700 44
42 40
600 40 38

500 29
30
400
23 21
300 20
200
10
100
0 0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Source: Associazione Bancaria Italiana (ABI). Source: Associazione Bancaria Italiana (ABI).

This is the outcome of an intense domestic consolidation started in 1997 and ended
in late 2002/beginning of 2003 (after Germany, Italy has seen the highest number of
transactions over the past 10 years). As a result, the average size of Italian banks has
increased significantly over the past 10 years: the total assets of the three largest
banking groups has almost trebled from 1993 to 2002.

2
Italian Banks, a Ten-Year Revolution, Associazione Bancaria Italiana, October 2003.

4
Italian Banks – 19 January 2005

Figure 3. Europe — Total Number of Mergers and Acquisitions of Figure 4. Italy — Average Total Asset of the Major Banking
Control Stakes, 1991 - 2002 Groups, 1993 - 2002 (Euros in Billions)
1,200 250
1,100
1,100 225
1,000
200
900 233
175
800
700 150

600 555 125

505
500 100 96

400
75
300
224 50
198 190
200
100 85 69 25

0 0
Germany Italy France Spain UK Austria Belgium Netherlands 1993 2002

Source: Associazione Bancaria Italiana. Source: Associazione Bancaria Italiana.

In spite of the reduction in the number of banks and the increased concentration in
the Italian banking system, Italy does not appear to be more fragmented than other
European countries: the assets of the first three largest banking groups account for
55% in Italy versus 56% in France and 51% in the UK.
Figure 5. Europe — Share of Top Five Banking Groups Assets as a Figure 6. Europe — Market Capitalisation of the 20 Largest
Pct of Total Assets, 2001 (Percent) Groups (US Dollars in Billions, Prices as at 14 January 2005)
100% 200
90% 175
90% 180
79% 160
80%
140
70%
63% 120
60% 55% 56% 96
100
51%
50% 81
80 75
68
38% 60 60 59 56
40%
47 45 43 43 41 38
40 35
30% 31 26 25 25 24
20
20%
0
10%
S
Sa BS

Llo BVA
BC

ed SB

I
s

as

AB ank

it A ro

Un o l e

sa

np ea

Ho a
Ba e r

he n

ng
nc ito

IM
la y

i
iss

e
RB

BN HBO

KB Dex
m
d

rib

nte

S a or d
G

Ba r e d

ldi
U
HS

Cr s T

ic
an

lo
De Soc

Cr N A
rc

Su
B

gr
Pa

ao
aI

N
nt

yd

ic

0%
it
P

C
sc

ed
ut

Germany UK Italy France Spain Switzerland Netherlands

Source: Associazione Bancaria Italiana Source: Datastream and Smith Barney

Italian banks and foreign ownership

We believe it unlikely that the Bank of Italy will allow foreign
stakes to increase beyond the 10-15% threshold, the maximum currently held by
non-domestic players. The Governor of the Bank of Italy (Mr. A. Fazio) has reiterated
this view and in a recent press article3 the Italian Prime Minister (Mr. S. Berlusconi)
expressed his full agreement with the Bank of Italy Governor regarding limiting
foreign ownership of Italian banks.
Banca Intesa’s management stated that Italian banks are among the most open
in terms of foreign presence within the shareholder structure.

3
Bloomberg – 14 January 2005, 18.45.

5
Italian Banks – 19 January 2005

In fact, currently BNL is owned 15% by BBVA, Banca Intesa 15% by Credit
Agricole, Sanpaolo IMI 9% by BSCH, Capitalia 9% by ABN, and Antonveneta 13%
by ABN. It is true that none of the positions built by foreign players in Italian banks
are controlling stakes, but they are part of shareholders’ pacts. Apart from the UK
market (Abbey National), eastern European countries and Bank Austria, we see few
examples of substantial/controlling stakes owned by foreign banks among western
European banks (ie France, Germany, Italy, Nordics).
Figure 7. European Banks — Stakes Owned by Foreign Institutions, 2004
Bank Foreign Shareholder Stake

Italian Banks
Banca Intesa Credit Agricole 15%
Banca Intesa Commerzbank 3%
BNL BBVA 15%
Antonveneta ABN 12%
Capitalia ABN 9%
Sanpaolo IMI BSCH 9%
Unicredito Allianz 5%
Unicredito Aviva 3%
Western European Banks
Bank Austria HVB 78%
Commerzbank Generali 10%
BCP Banca Intesa 7%
Royal Bank of Scotland BSCH 3%
BSCH Royal Bank of Scotland 3%
BSCH Sanpaolo IMI 3%
Source: Smith Barney.

The reason behind such a protective attitude is that central bank would like to maintain
a banking system willing to provide credit to their domestic corporate.

6
Italian Banks – 19 January 2005

A Brief History of Domestic Deals

➤ Generally, domestic consolidation has been driven by the desire to
increase exposure in the northern regions, and the aim of leveraging
on vast, untapped deposits bases to increase penetration of lending
and asset management.

➤ Looking at the main transactions that occurred between 1999 and

2003 revenue synergies seemed more relevant than cost synergies.

➤ The cost synergies targeted in domestic Italian deals were at the

bottom end of the European experience; in our view, this is due to
the limited flexibility management has on headcount.

➤ The vast majority of the targeted cost synergies were driven by

headcount reduction and integration of IT platforms

Above we highlighted that there has been a great deal of M&A activity in the past
few years in Italy. Below we explore the rationale behind previous deals in order
to ascertain potential future domestic consolidation.

The rationale for past domestic deals

We analyze the most relevant transactions taking place over 1999-03, which attempted
to create a more limited number of efficient and competitive players active in the
traditional businesses (lending) as well as in innovative services (asset management).
Figure 8. Italian Banks — Most Relevant M&A Transactions, 1999 - 2003
Announcement Acquirer Target

Late 1999 Monte Paschi BAM

Late 1999 Banca Intesa Comit
Early 2000 Monte Paschi Banca Salento
Mid 2000 Sanpaolo Banco Napoli
Late 2001 Sanpaolo Cardine
Early 2002 BPV BPN
2000-02 BP Lodi Savings Banks
Early 2003 BP Bergamo BPCI
Source: Company presentations and Smith Barney

The rationale for these transactions can be summarised as follows:

➤ Market share increase in geographic areas of low presence (mainly north of
Italy), eg BPV-BPN, Sanpaolo-Cardine, BPU-BPCI and Monte Paschi-BAM.
The aim was mainly to find scarce branches overlap, in order to avoid local
franchise disruption.
➤ Leveraging on a vast, untapped deposits base to increase lending and penetration
of asset management thanks to transfer of best practice, eg Sanpaolo-Banco
Napoli, Sanpaolo-Cardine, BPV-BPN.

7
Italian Banks – 19 January 2005

➤ Industrial fit among completely different entities, attempting to diversify the

revenue mix and lower the revenue risk profile. The most relevant case we can
identify is Intesa-Comit, in which a retail bank (Intesa) launched a bid for a
corporate and wholesale bank (Comit).
➤ Cost savings related to staff redundancies and integration of functions (IT, back
office, logistics, procurement, branches rationalisation).
On the back of these reasons and the deal timings, the transactions saw a high
degree of revenue synergies as a share of total synergies. We calculate that revenue
synergies accounted for more than 50% of total targeted synergies.
Figure 9. Italian Banks — Average Revenue and Cost Synergies Figure 10. Italian Banks — Average Revenue Synergies as a
Split in Recent M&A Transactions, 1999 - 2003 (Percent) Percentage of Revenue Base in Recent M&A Deals, 1999 - 2003
60% 14%
52%
48%
50% 12%
11%

10%
40%

8%
30%

6%
20%
4%
3%
10%
2%

0%
0%
Cost Synergies Revenues Synergies
As % of Target Total Revenues As % of Combined Total Revenues

Source: Company presentations and Smith Barney analysis

Source: Company presentations and Smith Barney analysis

Figure 11. Italian Banks — Revenue and Cost Synergies Split in Figure 12. Italian Banks — Revenue Synergies as a Percentage of
the Most Recent transactions, 1999 - 2003 (Percent) Target Revenue Base in Recent M&A Transactions, 1999 - 2003
100% 25%

90%

80% 20%

70%

60% 15%
50%

40%
10%
30%

20%
5%
10%

0%
MPS-BAM BdR-Mcc- Intesa- MPS-Banca Sanpaolo- Sanpaolo- BPL- BPV-BPN BPB-BPCI 0%
BdS COMIT Salento B. Napoli Cardine Savings MPS-BAM BdR-Mcc-BdS Intesa-COMIT MPS-Banca Sanpaolo-B. Sanpaolo- BPV-BPN BPB-BPCI
Banks Salento Napoli Cardine
As % of Target Total Revenues
Cost Synergies Revenues Synergies

Source: Company presentations and Smith Barney analysis Source: Company presentations and Smith Barney analysis

8
Italian Banks – 19 January 2005

Cost savings targeted in mergers and acquisitions

Despite the focus management has put on revenue generation, we believe that cost
synergy analysis is more interesting for the following reasons:
➤ Cost synergies are controllable by management;
➤ Revenue synergies, by their nature, are more dependent upon broader
macroeconomic conditions. In fact, considering the period during which
M&A plans were made (a buoyant economy over 1999-01) and the significant
macroeconomic deterioration that followed in 2002 and the beginning
of 2003, in most cases the Italian banks failed to deliver the promised
revenue generation.
We calculate that, on average, targeted cost synergies accounted for 4% of the
combined entities’ cost base and 14% of the target cost base. In our analysis of the
most recent M&A transactions, we calculate that more than 50% of the targeted cost
synergies were expected to derive from staff reduction programmes, mainly due to
centralisation of functions (product factories, back office, IT, headquarters). This is
no surprise given that staff costs represent almost 60% of Italian banks’ total costs.
Figure 13. Italian Banks — Average Cost Synergies as a Percentage Figure 14. Italian Banks — Breakdown of Costs Synergies as a
of the Cost Base in Recent M&A Transactions, 1999 - 2003 Percentage of Costs Synergies in Recent M&A Deals, 1999 - 2003
16% 60%
14% 53%
14%
50%

12%
40%
10%

8% 30%
25%
22%
6%
20%
4%
4%

10%
2%

0% 0%
As % of Target Total Costs As % of Combined Total Costs Staff Costs IT Platforms Other Costs

Source: Company presentations and Smith Barney analysis Source: Company presentations and Smith Barney analysis

The targeted cost synergies in domestic Italian deals match the bottom of the range
of the European in-market transactions (excluding postal bank acquisitions), which
we calculate have historically generated cost synergies ranging from 15% to 46% of
the target bank’s cost base.

9
Italian Banks – 19 January 2005

Figure 15. European Bank M&A (ex Italy) — Cost Synergies of Previously Announced Mergers
Type Acquirer Country Target Country Year % Target Costs

Cross-border Santander Spain Abbey UK 2004 19%

MeritaNordbanken Nordic Unidanmark Denmark 2000 11%
MeritaNordbanken Nordic Christiania Norway 2000 11%
Nordbanken Sweden Merita Finland 1997 7%
In-market BBV Spain Argentaria Spain 1999 46%
Lloyds TSB UK C&G UK 1994 31%
RBS UK Natwest UK 2000 77%
SHB Sweden Stadshypotek Sweden 1997 70%
Halifax UK Bank of Scotland UK 2001 32%
SBC Switzerland UBS Switzerland 1997 45%
Santander Spain BCH Spain 1999 44%
Bank Austria Austria Creditanstalt Austria 1997 41%
Danske Bank Denmark RealDanmark Denmark 2000 37%
DnB Norway Gjensidige Norway 2003 37%
Lloyds UK TSB UK 1995 31%
Vereinsbank Germany Hypobank Germany 1998 30%
SEB Sweden Swedbank Sweden 2001 18-22%
BNP France Paribas France 1999 17%
Credit Agricole France Credit Lyonnais France 2003 15-19%
Postal bank Den norske Bank Norway Postbanken Norway 1999 16%
Sampo Finland Leonia Finland 1999 13%
Nordea Sweden Postgirot Sweden 2001 8%
Bancassurer SEB Sweden Trygg Hansa Sweden 1997 25%
Fortis Belgium Generale Bank Belgium 1998 12%
Credit Suisse Switzerland Winterthur Switzerland 1997 4%
Source: Company reports and Smith Barney analysis.

In our view, the fact that Italian in-market deals targeted lower levels of cost
synergies reflects the low flexibility that management can achieve on the headcount
side and the weight that staff costs have on the overall cost base.
Figure 16. Selected European Banks — Staff Costs as a Pct of Figure 17. Selected European Banks — Cost to Income Ratio by
Operating Costs by Country, 2000-03 Country, 2000-03
70% 100%
2000 2001 2002 2003 2000 2001 2002 2003
65%
90%

60%

80%
55%

50% 70%

45%
60%

40%
50%
35%

30% 40%
France/NL Germany/Austria Italy Scandinavia Spain Switzerland UK/Ireland France/NL Germany/Austria Italy Scandinavia Spain Switzerland UK/Ireland

Source: Company data and Smith Barney. Source: Company data and Smith Barney.

10
Italian Banks – 19 January 2005

Generally, in an Italian context, this flexibility is limited by rigid labour legislation.

In Italy, significant workforce reduction plans (at reasonable prices) can only be
achieved through the use of the fondo esuberi, which allows management to target
the exit of personnel who have no more than five years to go before their retirement
age. Alternatively, headcount reduction plans may rely on voluntary redundancies,
which generally (and obviously) target the same employees as fondo esuberi.
Moving to other administrative expenses, we calculate that the biggest area of
rationalisation in previous Italian bank deals seems to have been the harmonisation
of IT platforms, in which Italian banks have invested significantly over the past
years. Typically these have had a tendency to overrun on time and costs, carrying
a high degree of execution risk.

11
Italian Banks – 19 January 2005

Efficiency Improvements in 2002-03

➤ In 2000-03, Italian banks maintained almost the same level of
efficiency, despite a very difficult revenue environment and despite
2000 being a peak year

➤ In some cases (revenue to RWA), Italian banks have bridged the gap
with their European peers, thanks to extensive revisions of their
asset bases

➤ Efficiency improvement has been achieved through the transfer of

best practices during consolidation and thanks to significant
standalone restructuring processes

➤ The strategic plans presented during 2002-03 put much more

emphasis on cost control than such plans had in the past; headcount
reduction has been predominant in achieving these targeted cost
control

Efficiency improvement achieved by standalone plans

Above we highlighted that the broad aim of the second wave of consolidation was
to create a more limited number of efficient and competitive players active in the
traditional businesses (lending) as well as in innovative services (asset management).
In our view, the transfer of best practices may have contributed to efficiency
improvements, but we believe that most of these improvements were due to the
restructuring that started in 2002, continued in 2003-04 and is still in place in 2005.
In fact, the aggregated cost to income ratio of Italian banks did not soar in 2002-03
from the levels of 2000, despite significant short-term rates cuts and collapsing stock
markets, which heavily impacted Italian banks’ revenue bases, given the significant
portion of their loan books at short-term and variable rates and their predominant
domestic positions in the production and distribution of asset management.

12
Italian Banks – 19 January 2005

Figure 18. Selected European Banks — Cost to Income Ratio by Figure 19. Selected European Banks — Cost to RWA Ratio by
Country, 2000-03 Country, 2000-03
100% 15%
2000 2001 2002 2003 2000 2001 2002 2003

90%
12%

80%
9%

70%

6%
60%

3%
50%

40% 0%
France/NL Germany/Austria Italy Scandinavia Spain Switzerland UK/Ireland France/NL Germany/Austria Italy Scandinavia Spain Switzerland UK/Ireland

Source: Company reports and Smith Barney analysis Source: Company reports and Smith Barney analysis

Figure 20. European Banks — Revenue to RWA by Country, Figure 21. European Banks — Pre tax Return on Equity by
2000-03 Country, 2000-03
20% 40%
2000 2001 2002 2003 2000 2001 2002 2003
35%
16%
30%

25%
12%

20%

8%
15%

10%
4%
5%

0% 0%
France/NL Germany/Austria Italy Scandinavia Spain Switzerland UK/Ireland France/NL Germany/Austria Italy Scandinavia Spain Switzerland UK/Ireland

Source: Company reports and Smith Barney analysis Source: Company reports and Smith Barney analysis

Figure 22. Selected European Banks — Bad Debt Charge on Figure 23. Selected European Banks Bad Debt Charge on
Customer Loans by Country, 2000-03 Operating Profit by Country, 2000-03
1.5% 90%
2000 2001 2002 2003 2000 2001 2002 2003
80%

1.2%
70%

60%
0.9%
50%

40%
0.6%
30%

20%
0.3%

10%

0.0% 0%
France/NL Germany/Austria Italy Scandinavia Spain Switzerland UK/Ireland France/NL Germany/Austria Italy Scandinavia Spain Switzerland UK/Ireland

Source: Company reports and Smith Barney analysis Source: Company reports and Smith Barney analysis

How did Italian banks managed to maintain a decent cost to income ratio despite the
uneasy revenue environment? By increasing the focus on cost control and using the
only lever that can generate sizeable cost saving over time — headcount reduction.

13
Italian Banks – 19 January 2005

The cost control efforts of 2001-03

Mindful of the failure to deliver planned revenues as presented in the late-1990s, and
of the macroeconomic weakness in 2002 and 2003, the standalone plans presented in
2002-03 put much more emphasis on cost and risk profile reduction than previously.
Here we focus on the cost savings efforts.
The cost reductions targeted in most of the M&A plans presented during 2002-03
were to be achieved mainly through staff reduction programmes, in some cases on
top of the ones made immediately after the last phase of M&A deals.
How did Italian banks manage to reduce headcount when the legislation is so rigid?
Mainly through the use of a tool created for this purpose, fondo esuberi. Banca
Intesa, BPVN, Monte Paschi and Sanpaolo IMI all managed to achieve significant
headcount reductions through the use of fondo esuberi.
The most significant plans presented in 2002-03 foresaw a net headcount reduction
of some 19,700.
Figure 24. Italian Banks — Targeted Net Headcount Reductions in the M&A Plans Presented in 2002-03
Staff Reduction Planned Net Staff Reduction Net Reduction (%)
Unicredito -1,750 3%
BNL -620 4%
Banca Intesa -7,200 14%
Capitalia -3,700 12%
Sanpaolo IMI -2,000 4%
Banca Antonveneta -900 8%
BPU -930 6%
BPVN -930 7%
Monte Paschi -1,700 6%
TOTAL -19,730 7%
Source: Company presentations and Smith Barney analysis

14
Italian Banks – 19 January 2005

Obstacles to Domestic Consolidation

➤ We do not assert that domestic consolidation in Italy has ended, but
we highlight some features that may prevent Italian banks from
achieving synergies in the event of further domestic consolidation

➤ High take-over premiums need to be backed by the ability to achieve

revenue and cost synergies

➤ We believe achieving revenue synergies is risky, as they are highly

dependent on the macroeconomic environment

➤ We believe the ability to achieve cost efficiencies has dwindled given

past headcount rationalisation and general stricter cost control

➤ Any consolidation among larger groups would involve tens of

thousands of employees and thousands of branches, possibly
resulting in local franchise disruption

Given the number of banks in Italy and their relatively small average size (if compared
to some of their European peers), domestic consolidation should be the most logical
step to make Italian banks bigger (in terms of assets and capitalisation) and prevent
foreign incursions. In this chapter we explore the opportunities for consolidation,
in light of the already increased efficiency achieved over the course of 2002-04.
We proceed assuming that the easiest way to make Italian banks bigger in a
European context would be, first, the largest groups buying medium-sized groups
and, second, consolidation within bigger groups. We examine opportunities and
obstacles related to increasing the size of the biggest groups.
The conclusion we come to is not that domestic consolidation in Italy has ended, but
that some features of the Italian market may prove obstacles to further consolidation
and to the achievement of decent synergies.

Popolari banks excluded from the game

Within medium-sized groups, cooperative banks (banche popolari) would represent
an obvious answer for further domestic consolidation.
On the other hand, popolari banks have peculiar corporate governance: only mutual
funds can hold more than 0.5% of the share capital of a popolari bank. However,
regardless of the size of the shareholding, voting rights are limited to one vote per
shareholder (per capita voting right). As a result of their historical close ties to the
local community, popolari banks have accumulated large numbers of employee and
customer shareholders. The peculiarity of the shareholders structure makes the sector
extremely difficult and unappealing consolidation target for private sector banks.

15
Italian Banks – 19 January 2005

Given that specific legislation would probably be required to change the status
of popolari banks (which would require time), we think it premature to state that
popolari banks will be transformed into entities that would make them easier and
more compelling to take over. We would exclude them from our current list of
possible players to be involved in any consolidation of Italian banks.
Figure 25. Italian Banks — Major Banche Popolari by Total Assets, 2003 (Euros in Billions)
Total Assets Market Capitalisation
Banche Popolari Unite 63 5.0
BPVN 49 5.4
BP Lodi 44 2.4
BP Milano 32 2.7
BP Emilia Romagna 19 2.6
Source: Company data and Smith Barney

More importantly, even if their status or corporate governance issues were changed,
in many cases, a takeover of popolari banks would not dramatically change the shape
and the size of the largest groups and make them bigger in a pan-European context.

Limited number of sizeable private sector banks

Once we have excluded the cooperative banks, we move to medium-sized private-
sector banks. The first feature to note is that there are not many. Regardless of their
profitability, location and shareholder structure, we have found very few names
that could change the size of the major domestic groups in a pan-European context
or create sizeable banking entities in any consolidation between themselves.
Instead of acquiring medium-sized banks, the largest banking groups could hoover up
many small banks. However, this process would be extremely lengthy and integration
problems would be multiplied by the number of small acquisitions. Ultimately,
management resources needed to realise merger synergies are not dramatically less if
the acquisition is small.
Figure 26. Italian Banks — Largest Private Sector Banks by Total Assets and Market Capitalisation,
(Euros in Billions)
Total Assets (December 2003) Market Capitalisation
Banca Intesa 260.2 24
Unicredito 238.3 26
Sanpaolo IMI 202.6 15
Capitalia 128.4 7
Monte dei Paschi 123.0 6
Mediobanca (June 2004) 31.8 10
BNL 81.1 6
Banca Antonveneta 47.6 6
Banca Lombarda 31.5 3
Credem 20.4 2
Source: Company Data, Smith Barney

Despite the high number of banks in Italy, the limited number of acquisition
candidates might result in a scarcity factor. On the one hand, this might drive share
prices up or lead to price wars in the event of multiple interests in the same entity
(with resulting benefit to the target’s share price). In addition, there is no apparent
need to sell banks: unlike in the first consolidation phase (rescue of banks in
financial distress), at the moment there are no banks in evident difficulty.

16
Italian Banks – 19 January 2005

Again, provided that medium-sized private-sector banks’ shareholders are willing

to sell (which we cannot forecast in any reliable way), this may drive share prices up.
On the other hand, the premiums paid in past transactions (high price to book
multiples, which were in many cases divorced from the actual target’s ROE) were
justified by significant revenue and cost synergies. While we believe that significant
progress was achieved on the cost side, we believe Italian banks have failed in the
delivery of targeted revenue synergies, mainly due to a macroeconomic environment
in 2002-04 completely different from that envisaged in the plans presented at the
time of the deals.
Figure 27. Italian Banks — Price to Book Multiples and Target ROE in Recent M&A Transactions (*)
14%

MPS-Banca Salento
13%

12%

11%
Sanpaolo-B. Napoli
10%
Intesa-COM IT

9% Sanpaolo-Cardine

8%

7% BPV-BPN
M PS-BAM
6%
0.0x 0.5x 1.0x 1.5x 2.0x 2.5x 3.0x 3.5x 4.0x 4.5x 5.0x

(*) Based on target’s ROE in the last year before acquisition.

Source: Company presentations and Smith Barney analysis

We wonder whether potential acquirers would now be prepared to risk diluting

their shareholders in the short term in the hope that aggressive synergies would be
achieved in the long term, when history shows that, because of variables not under
management control, revenue synergies were not delivered. Moreover, paying
multiples divorced from fundamentals and difficult to justify by overly aggressive
synergy targets might result in a loss of credibility and potential acquirers might
not be prepared to pay the high multiples of the past.
Previously, Italian banks clearly made backward steps in acquisitions in which the
price was considered excessive, so recently, despite wanting to acquire for the sake
of growth, banks have pulled out of their plans due to excessive multiples, eg Banca
Intesa with Garanti; and Unicredito with Banca del Gottardo.

Industrial overlap within major groups

In examining potential consolidation among the major groups, we should first
explore potential business combinations. Without attempting to provide an exhaustive
comparison (impossible given the mixed set of data provided by the different banks),
and despite different levels of efficiency and commitment, we would simplistically
suggest that, apart from Unicredito’s derivatives business, Sanpaolo IMI’s above-
average capital commitment to its insurance business, and Mediobanca’s pure
investment banking focus, the Italian banks’ business mix is pretty similar.

17
Italian Banks – 19 January 2005

Hence, in the event of consolidation among the major domestic groups, we would see
room for rationalisation of common businesses and possible transfer of best practices,
but we cannot find businesses entirely complementary.
In this case, on the revenue side, we highlight the following:
➤ In many cases, it would be a matter of transfer of best practices without the target
bank adding new revenue lines (no diversification of revenue sources).
➤ We would also question whether the transfer of best practices could be really
achieved in a reasonable period of time.
➤ The track record of Italian banks in achieving revenue synergies has not been
satisfactory (given the macroeconomic deterioration of the past few years).
Figure 28. Italy — Saving Industry Market Shares, November 2004

20% 19%

18%

16%

14% 13%
12%
12%

10% 9%

8%

6% 5%
4% 4% 4% 4%
4% 3%

2%

0%
Sanpaolo Unicredito Banca Generali Fineco- MPS Arca BPVN Ras BNL
IMI Intesa Capitalia

Source: Assogestioni

Geographical overlap within major groups

In recent M&A transactions, Italian banks have tried to avoid excessive geographical
overlap. Actually, one of the most relevant criteria for M&A transactions has been the
geographical fit (market share increase) in areas of scarce presence (mainly the north
of Italy), eg BPV-BPN, Sanpaolo-Cardine, BPU-BPCI and Monte Paschi-BAM.
Below we provide a table summarising the market shares in number of branches for
the major Italian banking groups in 2003, which could also be used as a proxy for
loans and deposits market share.
Figure 29. Selected Italian Banks — Branches Market Share by Region, 2003
Unicredito Banca Intesa SanPaolo Monte Paschi BPVN BNL Antonveneta Capitalia
North-West 9.9% 13.6% 10.7% 3.6% 5.9% 1.7% 1.7% 3.7%
North-East 18.0% 9.4% 10.0% 2.1% 5.5% 1.5% 5.5% 2.7%
Centre 7.9% 9.0% 4.2% 13.6% 1.4% 3.6% 2.3% 9.6%
South 6.1% 6.4% 18.2% 7.6% 1.1% 3.0% 3.2% 6.3%
Islands 4.1% 8.2% 4.5% 4.8% 0.7% 2.4% 6.1% 20.5%
Total 10.7% 10.1% 9.8% 5.9% 3.8% 2.3% 3.4% 6.3%
Source: Bank of Italy, Company data, Smith Barney analysis

18
Italian Banks – 19 January 2005

Given the current size of the largest groups, we find limited new potential geographical
fit and, more importantly, any new geographic synergies would be for the opposite
reasons than before: northern banks expanding their presence in the south rather than
strengthening their presence in the north.
The need to avoid geographical overlap is well explained by:
➤ The possibility of having to sell branches regardless of those branches’
profitability — a disadvantage to sellers forced to sell profitable networks,
possibly at low prices.
➤ Having to close branches would be even more problematic, as the headcount
in the branches could not be shed, but would have to be re-employed in other
tasks within the group.
➤ In addition, a fundamental restructuring of the branch network of the largest
groups would inevitably pose serious organisational problems involving thousands
of branches (not tens or hundreds as in the previous M&A wave) and tens of
thousand of employees, which may result in the disruption of the local corporate
and retail franchises in the medium term, with the risk that it not be restored.

Limited flexibility on headcount reduction

Theoretically, significant industrial/geographical overlap could lead to major
rationalisation/reorganization and result in substantial cost savings. However,
in Italy, achieving cost savings is ultimately a matter of staff reduction and the
flexibility on staff reductions is pretty limited for a wide range of reasons.
First, in Italy, major headcount reduction programmes (fondo esuberi) can only
target employees with no more than five years to their retirement age. Given that
the eligibility for a senior pension is 35 working years, the age of those employees
targeted is generally 55-60 years old.
Second, selective headcount reduction programmes through voluntary redundancy
(esodi incentivati) have no age constraints, but older employees not only have much
stronger incentives to leave their jobs, but represent higher weighted costs for the
banks. Overall, selective redundancy programmes (esodi incentivati) have the same
target as that of fondo esuberi, ie employees aged 50-60 years old.

19
Italian Banks – 19 January 2005

Figure 30. Italy — Eligibility Requirements to Qualify for Seniority Pensions, 1998-08
Private-Sector Private-Sector Public-Sector Public-Sector
Employees Employees Employees Employees Self-Employed Self-Employed

Year Age and Years Only Years Age and Years Only Years Age and Years Only Years
of Contribution of Contribution of Contribution of Contribution of Contribution of Contribution
Dini Reform (1995)
1998 54 and 35 36 53 and 35 36 57 and 35 40
1999 55 and 35 37 53 and 35 37 57 and 35 40
2000 55 and 35 37 54 and 35 37 57 and 35 40
2001 56 and 35 37 55 and 35 37 58 and 35 40
2002 57 and 35 37 55 and 35 37 58 and 35 40
2003 57 and 35 37 56 and 35 37 58 and 35 40
2004 57 and 35 38 57 and 35 38 58 and 35 40
2005 57 and 35 38 57 and 35 38 58 and 35 40
2006 57 and 35 39 57 and 35 39 58 and 35 40
2007 57 and 35 39 57 and 35 39 58 and 35 40
2008 57 and 35 40 57 and 35 40 58 and 35 40
New Reform (2004)
2008 — 40 — 40 — 40
Source: Fondazione Rodolfo DeBenedetti

Third, in several cases (Banca Intesa, Monte Paschi, Sanpaolo, BPVN) fondo
esuberi, the most powerful instrument to reduce the headcount at reasonable
costs, has already been used.
Fourth, the gross headcount reduction undertaken by the Italian banks over the past
two years is higher than the net reduction, as old employees have been replaced
partially by younger (and less expensive) employees. For example, Monte Paschi’s
targeted gross headcount reduction was 3,600, twice the net reduction. In November
2003 BPVN’s gross reduction was planned at 983, 1.5 times the net reduction.
Again, in the 2004-07 plan presented in October 2004, Unicredito planned 4,500
gross redundancies, 1.5 times the planned net reduction.
In other words, we argue that the reduction in the workforce aged 50-60 has been
more severe than the shown in Figure 31. Using the above examples, we would
estimate the headcount reduction at almost 29,000, instead of 19,000, or some
of the 11% of the workforce at the time of the publication of M&A plans.
Figure 31. Italian Banks — Targeted Net Headcount Reductions in the M&A Plans Presented in 2002-03
Staff Reduction Planned Net Staff Reduction Net Reduction (%)
Unicredito -1,750 3%
BNL -620 4%
Banca Intesa -7,200 14%
Capitalia -3,700 12%
Sanpaolo IMI -2,000 4%
Banca Antonveneta -900 8%
BPU -930 6%
BPVN -930 7%
Monte Paschi -1,700 6%
TOTAL -19,730 7%
Source: Company presentations and Smith Barney analysis.

Comparing this figure with the age breakdown provided by Unicredito during its
2004-07 business plan presentation (c14% of employees are aged 55-60 years old
before the start of the staff reduction programme), and assuming the Unicredito
breakdown as a proxy for the system, we argue the number of employees that could
be targeted for headcount reduction programmes represent c10-15% of the workforce.

20
Italian Banks – 19 January 2005

As we have previously calculated that the staff reduction plans launched in 2001-04
amounted to some 11% of the pre-M&A headcount, we argue that most of the
employees easily targetable for any new headcount reduction programmes are no
longer part of the Italian banking system.
Our opinion that this number was reduced significantly is reinforced by Monte
Paschi’s staff breakdown by seniority, according to which, as at June 2004, 13% of the
workforce had more than 30 years of seniority (the current limit is 38 years for 2005).
Finally, Sanpaolo IMI in its 2003 annual report4 states that leaving incentives were
actually offered to 3,750 employees out of about 4,800 identified as possible
redundancy candidates, or some 80%.
Figure 32. Unicredito Italiano — Headcount Breakdown by Age, Figure 33. San Paolo IMI (Commercial Banks Only) — Headcount
2003 Breakdown by Age, 2003
25% 40%
36%
22% 21% 35%
32%
20%
30%
16%
15% 25%
15%

20%
11% 17%
10% 9% 14%
15%

10%
5% 4%
3%
5%
1% 0%
0% 0%
up to 25 26-30 31-35 36-40 41-46 47-52 53-56 > 56 Up to 20 21-30 31-40 41-50 51-60 > 61

Source: Company presentations and Smith Barney Source: Company data and Smith Barney

Figure 34. Monte dei Paschi — Headcount Breakdown by Age, Figure 35. Monte dei Paschi — Headcount Breakdown by Years of
2003 Seniority, 2003
40% 40%

35% 33% 33% 35%

32%
31%
30% 30%
25% 25%
25% 25%

20% 20%

15% 15%
12%
9%
10% 10%

5% 5%

0% 0%
up to 30 from 31 to 40 from 41 to 50 more than 50 up to 10 from 11 to 20 from 21 to 30 more than 30

Source: Company data and Smith Barney Source: Company data and Smith Barney

Fifth, the already limited flexibility on headcount has been further reduced by the
introduction of new pension legislation — the government has introduced an incentive
for workers not to abandon their jobs when they would be legally entitled to retire5.
As a result, staff reduction programmes might become ~30% more expensive in the
coming years.

4
See Sanpaolo IMI 2003 Annual Report, page 58.
5
The government has introduced an additional ~30% to net monthly salaries to encourage workers at pensionable age to continue
working.

21
Italian Banks – 19 January 2005

Sixth, new legislative tools would be required to make job cuts easier in Italy. Given
that regional elections will take place in mid-2005 and national elections in mid-2006,
we do not believe it likely that new legislation will be introduced in the short term.
Overall, we conclude that further significant actions on the headcount side do not look
likely in the short term and, after the staff reduction programmes by Italian banks over
2002-05, there may be many years before a sizeable number of employees aged 55-60
could be encouraged to leave.

Limited flexibility on staff reassignment

Given that further movement on headcount does not look likely or easy in view
of what has already been done over the past few years and rigid labour legislation,
a possible way to increase productivity and profitability without recurring to headcount
reduction would be moving personnel to front-office activities from back-office
activities, or, in other words, to commercial functions. Most of Italian banks have
already shifted a portion of their personnel to sales functions. For example:
➤ In the plan presented at the time of the Cardine acquisition, Sanpaolo IMI aimed
to have 82% of the group’s headcount devoted to front office activities.
➤ In the plan presented in November 2003, Monte Paschi planned the
redeployment of some 1,900 employees, 7% of the overall headcount.

Conclusion
We do not assert that domestic consolidation in Italy is over, we just aim to highlight
some features of the Italian market that may prove obstacles to further consolidation:
➤ Popolari banks would be attractive assets, but a legislative change would be
required to make them part of the game
➤ Despite the high number of banks in Italy, medium-sized candidates for potential
acquisition by the large banking groups do not exist; even if they did, it would
not solve the problem of the relatively small average size of Italian banks
compared to the rest of Europe
➤ Geographical overlap within major banking groups would be significant and may
pose the following problems:
➤ Antitrust threats, ie the requirement to sell/close branches regardless of
economic rationale; and
➤ Any organizational change would involve thousands of branches and tens
of thousands of employees, which may result in franchise disruption
➤ Limited flexibility on headcount, given that most Italian banks have already
used or are currently using fondo esuberi; in our view, this would limit the ability
to achieve decent cost synergies at reasonable prices
➤ If headcount reduction proves difficult, staff reassignment to commercial activities
could be a way to redeploy employees, but moving personnel from back-office to
front-office functions is a process started years ago and still running

22
ANALYST CERTIFICATION Appendix A-1
We, Riccardo Rovere and Azzurra Guelfi, hereby certify that all of the views expressed in this research report accurately reflect our
personal views about any and all of the subject issuer(s) or securities. We also certify that no part of our compensation was, is, or will be
directly or indirectly related to the specific recommendation(s) or view(s) in this report.

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Banking.
Smith Barney Equity Research Ratings Distribution
Data current as of 31 December 2004 Buy Hold Sell
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Guide to Fundamental Research Investment Ratings:
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Investment ratings are a function of Smith Barney's expectation of total return (forecast price appreciation and dividend yield within the
next 12 months) and risk rating.
For securities in developed markets (US, UK, Europe, Japan, and Australia/New Zealand), investment ratings are: Buy [1] (expected total
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less for High-Risk stocks, and 20% or less for Speculative stocks).
Investment ratings are determined by the ranges described above at the time of initiation of coverage, a change in risk rating, or a
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the same as in the current system.

23
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