Aug 31st 2006 | MILAN, NEW YORK AND PARIS From The Economist print edition Italy wins tentative applause for a large banking merger FOR years the Italian banking system was described as a petrified forest—gloomy, immobile and rooted firmly in the past. None of the institutions within it had ever exactly been considered sleeping beauties either—they are costly for consumers, inefficient and poor lenders. But on August 26th a ray of sunlight shone through when Banca Intesa, Italy's second-biggest bank by assets, announced that it planned to merge with Turin-based Sanpaolo IMI, its next-largest rival. The aim is to create one of Europe's ten biggest banks (see chart), which, if run correctly, could give Italy the sort of financial heft it needs to stoke a sluggish economy. Like UniCredit, the country's biggest bank, Banca Intesa and Sanpaolo IMI have done more than their counterparts to shake the banking system out of its torpor. Over time, they have grown through a series of largely successful mergers—though none shines by international standards. Last year, UniCredit landed the most unexpected coup: it entered the European big leagues after taking over Germany's HypoVereinsbank. Yet Intesa and Sanpaolo IMI hope to catch up. If completed (they aim to do so by the end of the year), the merger would create one of Europe's biggest domestic banks. Italy would have a behemoth with some 6,000 branches and control of more than one-fifth of the retail market, much of it in the wealthier north. The new bank's stockmarket value of over €65 billion ($83 billion) would just surpass that of UniCredit. Corrado Passera, Intesa's chief executive, would take over as boss of the new bank. Many predict that Mr Passera would use the takeover of Sanpaolo IMI as a springboard for a big cross-border deal—as did Alessandro Profumo, boss of UniCredit and Mr Passera's arch rival. Investors' reaction to the proposed deal was enthusiastic. “This was the best deal the two banks could pull off given the limited options of partners in Italy,” says Marcello Zanardo at Keefe, Bruyette & Woods, an investment bank. Italy has some 700 banks, but most of them are almost impossible to buy, or not worth buying. A few are controlled by foundations unwilling to cede control; some are banche popolari, mutual banks, which accord a single vote to each shareholder. Provided the merger is as much about synergies as size, it should be good for profits. According to Matteo Ramenghi, an analyst at UBS, an investment bank, previous mergers resulted in cost savings of more than 17% of the acquired bank's costs. Mr Passera has a reputation as a cost-cutter. The new bank is also planning to separate itself from some 600 overlapping branches. Most of them are likely to be sold to Crédit Agricole, Intesa's biggest shareholder, to sweeten the deal for the French bank. Mario Draghi, appointed this year as governor of the Bank of Italy, is keen to see more consolidation to strengthen Italian banks against predators from other countries. The most obvious takeover candidates are Capitalia, a Rome-based bank, Monte dei Paschi di Siena (MPS) and Mediobanca, a Milan-based investment bank. But none would be easy: Matteo Arpe, Capitalia's boss, is keen to protect his bank's independence and likely to demand the top job in any merger talks. A foundation owns 58% of MPS. And Mediobanca is controlled by a shareholder pact that includes Capitalia and UniCredit. The real test of the desire to unify Italy's fragmented banking sector would be the abolition of a law awarding a vote per head to shareholders of banche popolari, says Claudio Scardovi at Mercer Oliver Wyman, a consultancy. This makes such banks, which control about 40% of the retail market, nearly takeover proof. Banca Popolare di Milano, for instance, is in effect controlled by its large employee union, which has just 3% of the capital. At the moment, the mutual banks can be taken over only if they wish to be. Only one, Banca Popolare Italiana (BPI), based in Lodi, northern Italy, has put itself on the block. Four banks have expressed interest. The BPI auction and Mr Draghi's appointment as head of the central bank are the result of the scandal last year that led to the resignation of his predecessor, Antonio Fazio, amid criminal investigations and the publication of (unexpectedly entertaining) transcripts of his scheming telephone conversations. For more than a decade Mr Fazio had obstructed all foreign bids for big Italian banks and some mergers between domestic ones. So far Mr Draghi has made a strong start. Some of the central bank's power to meddle has been reduced. France's BNP Paribas encountered no resistance to its swoop on Banca Nazionale del Lavoro in February. Another test of Mr Draghi's appetite for change would be his attitude if a foreigner bid for Capitalia, MPS or Mediobanca. All three of them are banking jewels. It is bound to be tempting to protect their italianità.