The BBVA/Sabadell operation serves as a test case for greater banking consolidation in Europe.

Rising interest rates boost profits for Spanish retail banks, attracting buyers of its shares last year. But investors aren’t the only ones taking notice of these groups; others have done it toobanking executives.

Tuesday afternoon BBVA has confirmed reports that it is preparing an offer for Banco Sabadell. While the industrial logic makes sense for BBVA, for the operation to increase the group’s pro forma earnings per share significant cost reduction.

BBVA may expand its business in Spain. especially in small business lending. Almost three-quarters of revenue comes from outside Spain.mainly from Mexico and TürkiyeEstimated by Visible Alpha.

A previous attempt to merge both entities in 2020 failed.. Today such a combination would create second largest bank in the country, worth almost 70 billion euros. It’s possible that BBVA was spurred to action there are rumors that Sabadell himself may buy Unicaja.

Southern European banks have been the biggest beneficiaries of the sector this year. The fact that the European Central Bank is set to cut rates more slowly than expected, coupled with lower deposit outflows, improves the outlook for net interest income. Sabadell shares are up more than 66% this year.including the 5% recovery recorded on Tuesday.

But Sabadell’s rising valuation makes it difficult for BBVA to justify this combination.. Assuming BBVA opts for an all-share deal to avoid reducing its capital reserves, any apparent valuation arbitrage between the two banks would disappear. Both companies now have the same valuationThat’s just over seven times earnings forecasts, according to Bloomberg data.

Therefore, cutting costs is essential to the deal. BBVA’s expected return on tangible equity this year is 15.5%, 4 points higher than Sabadell’s. The latter has a cost-to-income ratio of about 51%, which is significantly higher than BBVA’s 42%.

Regulators will likely be supportive. Domestic consolidation should improve scale, leading to increased profitability. This is based on large overlap between the national networks of branches of both entities, which Barclays valued at approximately 1,200 at the time of the last merger attempt. BBVA will have to achieve cost savings equivalent to 15% of Sabadell’s total operating expenses after taxes.about 312 million euros this year.

If BBVA pays much more than Sabadell’s closing price on Tuesday, the operation may reduce profits. This explains why shareholder selling sent BBVA shares down more than 6%. Regardless of the logic BBVA should carefully examine any price offered by Sabadell.

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