Outlook: Don't trust this banking euphoria

WHETHER OR not the banking sector is already through its dark night of the soul - or, as seems more likely, only half way - the prospect of banking mergers and consolidation is already back at the top of the agenda, strongly lifting the mood in markets in the process.

Some of the reasons for this are entirely logical. Sir Brian Pitman, chairman of Lloyds TSB, made the obvious point at a banking conference this week that the shake out in share prices among financial stocks should help speed consolidation, if only because valuations are now at more affordable levels.

It scarcely needs saying that the more markets take cognizance of this observation, the less likely it is to happen, since the effect is once again to drive valuations beyond everyone's reach. Already many international banking stocks are 30 per cent off their lows. All the same, if you believe, as Sir Brian does, that there is too much capacity and an excess of capital in financial services, then it is plainly right to think this set back in share prices could prove the catalyst.

On the other hand it is not altogether clear why news that Deutsche Bank may be in preliminary talks to buy Bankers Trust, and growing speculation that Dresdner is doing the same with Lehman Brothers, should generate such a euphoric response. Were these two deals to happen at all, they would almost certainly be distress sales.

The prospect of paying book value for a bank, when just six months ago it would have cost twice as much, is only appetising if the purchaser can be sure of what he's buying. Given the rumours of financial difficulties that have surrounded these US banks - vehemently denied in both cases - extreme caution will be the order of the day.

This is all the more so for Deutsche, whose record of running an integrated investment bank has been poor. Furthermore, neither of these firms are bulge bracket; the Germans would be buying into the second tier of the US investment banking franchise, which in itself might seem unwise in present market conditions. Deutsche has built quite a reputation for destruction of shareholder value in recent years, but even taking the long, teutonic view, Frankfurt is going to have big doubts about any transaction of this sort.

However unlikely it is that Deutsche will be persuaded to come riding to the rescue, the story certainly cheered markets yesterday. Having crashed so seriously for the past three months, equities are now busily uncrashing, just as they did a year ago.

After the rally of the last week, the Dow is little more than eight per cent off its peak, and as far as the year as a whole is concerned, it's showing a remarkably healthy 10 per cent return. Likewise, our own stock market is staging a strong recovery. So are we through the worst, or is this just a lull in the storm?

The honest answer is that it is impossible to tell. Don't believe any pundit who says otherwise. Conditions remain treacherous in the extreme and only the brave - step forward Abby Cohen of Goldman Sachs, who still believes the Dow is heading for 10,000 over the next year - will venture out in these winds.

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