The next wave of European retail banking consolidation is at hand. Several retail banking behemoths are up against the limits of national expansion and must look across their countries' borders to find growth. Sizable cross-border mergers have already occurred in Scandinavia, the Low Countries, Spain, and Portugal. But this is only the beginning.

In this consolidating market, bigger banks will find that their enduring advantages lie in scale and reach. Their millions of customers, multichannel distribution networks, and massive investments in information technology are their greatest competitive strengths. The experience and skill of senior executives in managing these leviathans are also considerable advantages.

Given how important scale will be in the pan-European market, well-orchestrated mergers of equals will probably be the best way for big banks to expand across national borders. Our firm's research shows that such mergers enable two big banks to cut their combined costs by up to 10% - provided the deal is conceived and executed carefully. Of course, managers must understand how their banks' individual businesses would fit together before embarking on an acquisition.

Already, some banks are finding profitable ways of merging across borders despite national and cultural differences. For example, Merita-Nordbanken, the Finnish-Swedish merger, is cutting costs and realizing benefits by integrating head offices and information technology development while sharing best practices (for example, marketing Nordbanken's mutual funds to Merita's customers). The post-merger bank, which already has more than six million customers, is now expanding into Norway.

Big banks have no choice but to pursue pan-European strategies. The current run of increasingly large domestic retail banking mergers is now in its last act. Spain's BBV and Argentaria are merging. Bank of Scotland and Royal Bank of Scotland launched audacious bids for NatWest. Fewer big local players increasingly dominate each national market. Already, the top five British banks have 75% of their national personal loan market. In Spain, the five largest have more than 70% percent of the country's deposits and 80% of mortgages. In the Netherlands, the five leading Dutch banks have 84% of the country's deposits and 85% of bank loans. These titans are already close to the limit of what European regulators permit.

But the pressure is intensifying to consolidate further and achieve greater scale. Margins are declining, and cost-to-income ratios are hard to cut without mergers. Only a few banks, including Banco Popular and Lloyds TSB, have reduced costs significantly. Many others, notably in Germany, have been less successful.

Meanwhile, nimble newcomers - like ConSors, Direkt-Anlage Bank, E-Trade, Egg, E-Loan, first-e, and Insuremarket - come armed with new technologies, tight business focus, the power to exploit the Internet, and strong brands. They are venturing into the richest financial markets. Though their market shares may still be small, their impact on margins is significant. For example, pressure from new competitors like British Gas' Goldfish and MBNA Corp. has caused credit card margins in the United Kingdom to shrink to an average of 12%, from nearly 20%.

Consumers, meanwhile, want more than ever. They seek the latest channels but still demand access to branches - which only adds to technology and distribution costs. Established banks must also adapt to the common European currency and respond quickly to the need to increase shareholder value in Europe's more integrated and demanding capital markets.

Facing these challenges, it may seem tempting to argue that banking giants should break themselves up and focus on their constituent businesses. But such an approach would ignore the real advantages these incumbents have: scale, reach, and enduring relationships with huge numbers of customers.

Banks need to revisit their strategies. The sooner they do so, the more likely they will be to forge a winning approach. Here are some guidelines:

  • Act boldly to achieve scale and to consolidate. The car, food distribution, and pharmaceutical industries have consolidated across borders; financial businesses are not far behind. Recognize that Europe is reaching the endgame in domestic financial consolidation.
  • Think big. Incremental moves across borders will not do. Organic growth in foreign retail markets will produce insufficient value. Small acquisitions, such as those tried by Credit Lyonnais in Germany and the Netherlands, have proven disappointing. Small cross-border investments have little influence.
  • Don't be intimidated by cultural differences. They have not hampered cross-border acquisitions in other industries. If such differences are addressed thoughtfully, they can be turned to the post-merger institution's advantage. The new entity can retain the best of each firm's culture in an increasingly heterogeneous market.
  • Focus on what you excel at. Invest aggressively in your strongest or most promising businesses. Look carefully for good fits between your business and opportunities in other markets. Be ruthless about quitting unprofitable businesses. Be willing to outsource to cut costs.
  • Be a shaper, not a follower. It is merely a matter of time before this new wave of consolidation strikes. Take the initiative with your institution before someone else does. The financial markets reward banks that successfully consolidate and cut costs - witness the merger of Lloyds and TSB, and of Chase and Chemical. However, they punish those that merge but fail to realize cost savings. In the rapidly consolidating European market, even a bank that has a huge share of one or two national markets will have only a small share of the market overall. That is why large institutions should focus on what they do best.

They should exploit their scale, reach, and customer rolls to build pan-European businesses. Mr. Rhodes is a vice president in the London office of the Boston Consulting Group; Mr. Rocco is a vice president in the firm's Milan office; and Mr. Buerkner is a senior vice president in its Frankfurt office.

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