Bank of Ireland pitches for the big time

Buying Abbey would make the Irish bank a force to be reckoned with, but the City is not convinced

Abbey National is a bank that knows that life is complicated enough, which is why Lord Burns, chairman of the struggling bank, must have opened the Sunday papers this weekend with a sigh. There he found stories about how Bank of Ireland, a smaller rival, is keen to buy the UK's sixth-biggest bank.

Of course Lord Burns, the former Treasury mandarin, knew about the offer before it appeared in the papers. Laurence Crowley, governor of Bank of Ireland, called him personally to propose the deal three weeks ago.

Since then Lord Burns has had rather a lot on his mind. He was getting close to filling the post of chief executive, vacated in July with the departure of Ian Harley, so he had not got back to Mr Crowley. Lord Burns will do that in the next few days, with an answer which is almost certain to be "no".

It seems that Mr Crowley and his ambitious board had been more optimistic about their chances of creating a bank worth £15bn, which might squeeze itself into the ranks of the five biggest in the UK.

Bank of Ireland, the Republic's second-biggest bank, argues a tie-up with Abbey could produce lots of benefits. It has a solid reputation in wholesale banking, an area in which Abbey has made enormous mistakes. It could also improve Abbey's relationships with customers. Bank of Ireland sells on average three products to each person who banks with it, compared with an average of two products among European banks.

The Irish bank has pointed to potential cost savings, especially with Bristol & West, its UK financial services business. Analysts believe the main cost saving would be a "slash and burn" of Bristol & West, including large scale branch closures, or even selling the whole business off.

These arguments have not found much favour in the City. The cost savings are not thought to be more than £200m a year, summed up as "useful but not overwhelming" by Martin Cross, an analyst at Teather & Greenwood.

Abbey's shareholders have also reacted without enthusiasm to the approach which comes at a time when the UK bank's shares have hit fresh lows – last week they fell to just over £5, their lowest in seven years.

One institutional investor said: "This is opportunistic and we think Abbey is right to reject the proposal. Abbey could go to £6.50 even with a rally in the market so that kind of a price in the deal would not be acceptable."

David Lis, UK fund manager at Morley Fund Management, which is one of Abbey's five largest fund managers, added: "A nil-premium merger makes little obvious sense."

Bank of Ireland has even come under fire for its method of approach to Abbey. "Abbey is not going to take them up and they are unlikely to go hostile, so where do they go from here? They look rather vulnerable to a hostile bid of their own. This is not Riverdance – you need a bit more fancy footwork in the City," one observer said.

The timing of the Bank of Ireland approach has been inconvenient for Abbey. It became public just two days before Lord Burns was due to sit down with the short list of candidates to fill the top job.

But the lack of seriousness that has greeted the offer has been a relief for Abbey's board, which is keen to press ahead with finding a new chief executive to put the bank back on the rails before seriously considering any merger proposals.

Those in the banking sector believe there is plenty of room for improvement. In the past year, Abbey is seen to have mismanaged its wholesale banking division, leading to substantial bad debts. Its life arm also looks weak and has required two injections of capital and speculation is rife that it will have to halve its dividend.

While synergies with Bank of Ireland would be limited, analysts believe there is plenty of room for cost cutting within Abbey itself. One said: "Abbey is not full of fat in the way that NatWest was before it was taken out by Royal Bank of Scotland. But it could take 10 per cent out of its cost base – or £150m to £200m a year."

Abbey said at the time of its interim results that it planned to cut back its wholesale bank. The indications are that Abbey will return to its roots of retail banking, but even here it has work to do to catch up with competitors.

This year the bank took 7 per cent of new mortgage lending, half of its share of outstanding loans. One rival said: "If Abbey can't even get this right, what can it do? It is now punching below its weight, which is a real problem."

Abbey also has to sort out its struggling life arm. The bank could reduce its three brands – Scottish Provident, Scottish Mutual, and Abbey National Life – to one and merge more of their back office operations.

Jon Kirk, an analyst at Fox-Pitt Kelton, pointed out that Abbey's impending appointment of a new chief executive presents an opportunity for Abbey to address its manifold problems.

"The new chief executive will have a mandate to kitchen sink – possibly taking massive write-downs on the embedded value and whole arm and cutting the dividend. Once this has been done and we can have some visibility of earnings in the future, that could be the turning point for Abbey," Mr Kirk said.

Observers say a comparison between Abbey and NatWest before its takeover by RBS is unfair, but they do point to similarities with the state of Barclays five years ago.

One banking executive said: "Barclays had problems with its lending, problems with its retail bank and a divided board. That looks quite like Abbey now and if they would get someone in to talk some common sense, it could be a new business."

Names that have been mentioned in connection with the Abbey job may well relish the challenge of turning the bank around. They include John Stewart, the deputy chief executive of Barclays, Gordon Pell, the respected head of Coutts, and Eric Daniels, the head of retail banking at Lloyds TSB.

But they, and Abbey's board, know that their opportunity to prove themselves to the bank's aggrieved shareholders will be brief.

Many shareholders look back ruefully on the £13 a share offer Lloyds made for Abbey last year. In the event, Lloyds' offer was blocked by the Competition Commission over fears about the market share of the combined entity. But Mr Harley, who quit after the emergence in the summer of problems at the wholesale bank, was particularly associated with the fight against Lloyds.

There are now plenty of other banks that have made their interest known in Abbey. The UK's Big Four were effectively ruled out by the Competition Commission's findings, but a number in Europe and elsewhere are eyeing the UK market. Abbey's most persistent suitor is National Australia Bank. The two were in talks in the summer, which could be resumed at any time.

One City source said: "Ian Harley did not primarily go because of the wholesale problems. He went because he blocked the Lloyds deal. Anyone who comes in now will have to bear in mind that if they do not persuade the market they can produce real results, shareholders will loose interest in backing them."