European Banks Analyst
After a tough start to 2016, many European banks now look extremely attractively valued. However, investors must tread carefully as some banks still carry elevated risks.
8 February 2016
2016 has certainly started in an “interesting” fashion for investors in bank shares – we are only one month into the year and already the FTSE Pan-European banks index is down some 14% compared to the broader market down 6% (as at 29 January 2016).
Relative to the broader equity market, the pan-European banks remain below the Global Financial Crisis lows of early 2009 and are now even below the euro crisis lows of mid-2012.
Should we be panicking? No, but as investors we need to continue to tread carefully.
Perhaps the most positive development we have seen in recent months is confirmation that we do, at last, have good visibility as to how much capital European banks will need to hold. This is important as it enables investors to firm up their analysis of returns as well as the potential for capital repatriation.
In the eurozone the Supervisory Review and Evaluation Process (SREP) has provided considerable clarity as to the European Central Bank’s (ECB) view regarding appropriate capital levels.
In addition, a number of national regulators have now published required domestic capital buffers for systemic institutions.
Like the Globally Systemically Important Bank (G-SIB) buffers these are additive to SREP requirements and form a key building block in management and the market’s understanding of “go to” capital levels for Europe’s banks.
Meanwhile, outside the eurozone, the Swedish financial supervisory authority published in November for the first time the individual capital requirements for the large Swedish banks (this exercise will be repeated quarterly).
Here in the UK, the Bank of England (BoE) has stated that UK banks now have broadly appropriate capital levels and consequently that further changes in regulation will be accommodated within existing buffers1.
Indeed, regulators are now going out of their way to clarify that there is no new wave of regulation coming.
For a handful of banks the fortunes of investors will inevitably be hostage to political and regulatory decisions.
The Basel Committee’s work programme for 2016 promises to continue important work to refine capital calculations, but “will focus on not significantly increasing overall capital requirements.”2
Whilst BoE Governor Mark Carney has stated that “while there are details still to be finalised and complexities to be reduced, there is no new wave of capital regulation coming. There is no Basel IV.”3
We need to remember that prudent management teams will need to run their banks with adequate buffers over minimum regulatory requirements – no CEO wants to have to unexpectedly limit discretionary dividend payments to equity shareholders or, worse still, additional tier 1 bondholders4.
Most banks are already in excess of known end-state (typically 2019) capital requirements and many are already generating good amounts of capital relative to both nominal leverage exposure and risk-weighted assets (the two key metrics for capital calculations).
However, there is a “tricky cohort” of banks that look set to disappoint overly-ambitious consensus dividend expectations, given inadequate buffers over minimum requirements.
This is where care in stock selection is important.
Recent years have seen bank profits in some countries crushed by the burden of high credit losses.
Conditions have already turned materially for the better in Ireland.
NAMA – Ireland’s bad bank – now looks set to be unwound earlier than originally envisaged with the state’s contingent liability expected to be eliminated by 2018, whilst Allied Irish Banks looks set for a return to public markets later this year.
Meanwhile, in Spain some banks continue to wade through the treacle of legacy real estate provisioning which may keep credit losses elevated for a while yet. Excluding this issue, loan books look to be on a rapidly improving trend.
However, in Italy the problem loan burden is proving large and difficult to shift.
There is a growing recognition amongst policy makers as well as regulators that the sheer volume of non-performing loans, amongst other factors, is inhibiting economic recovery.
With uncovered problem loans for many banks exceeding Core Tier 1 capital levels - the measure of a bank's financial strength from a regulator's point of view - the challenge is how to clear this blockage without forcing material losses onto shareholder and – potentially in some cases – bondholder shoulders.
For a handful of banks the fortunes of investors will inevitably be hostage to political and regulatory decisions over which they have little control or visibility.
For much of the rest of Europe the key risks surround energy and commodity exposures as well as emerging market vulnerabilities.
As investors we are working hard to understand not just the quantity, but more crucially the quality of bank exposures. On the whole, risks here feel very manageable but obviously some banks are more exposed than others.
To be clear, however, we are not on the cusp of another Global Financial Crisis.
2008 was very different with an unknown quantity of toxic AAA-rated instruments referencing US subprime mortgages warehoused in a banking system that lacked adequate capital and liquidity buffers.
Conditions today could not be more different.
Indeed, European banks have been in de-risking mode for some eight years now and so should represent something of a “safe haven” for investors in this regard.
Lower interest rates continue to exert downward pressure on returns
European banks look set to follow the Japanese playbook of margin contraction as the sustained pressure of lower interest rates eats into profitability.
However, this pressure is not uniform. Some banks are more dependent on net interest income than others.
In addition, assets and liabilities reprice at different speeds across the continent. This is important to understand.
For example, a mortgage in Spain or Italy has a fixed spread over Euribor5. This cannot be varied over the life of the contract (typically 25 years).
At the other extreme, the bulk of mortgages in Norway and Sweden, for example, can be repriced by the banks as frequently as every two to three months.
Some banks are therefore far better-placed than others to defend profitability in a sustained low interest rate environment. Again, this is where stock selection can be crucial for the bank investor.
At current share prices, upsides to fundamentally-driven price targets are now looking eye-wateringly attractive for a large number of banks. If the world successfully navigates the combined effects of a China slowdown and sharply lower commodity prices, then bank share prices could rally very sharply.
However, even if this does happen the path will not be smooth (indeed the enhanced price volatility we see in numerous asset classes represents an unwelcome side effect of tighter post-crisis bank regulation).
We are not on the cusp of another Global Financial Crisis.We are not on the cusp of another Global Financial Crisis.
In this sense it is critical to understand not just how much upside there may be in the shares of any one bank, but how this upside is expected to be delivered.
In uncertain times, cash dividends should be valued particularly highly. The good news here is that numerous banks now offer pretty secure dividend yields as high as 5-6% today, rising to as high as 7-8% a couple of years out.
Many others offer material fundamental upside which is more contingent on return on equity6 improvement two to three years out with precious little in the way of cash return – something investors will be reluctant to pay up for in today’s risk-off environment.
European bank shares have fallen to optically attractive levels at the same time as capital requirements have become far clearer.
Whilst there is a risk to consensus dividend expectations for a cohort of stocks, many banks offer immediate safe and attractive cash dividend yields which, as a minimum, should act to underpin share prices.
Some banks continue to have legacies from the past that need to be addressed and there are risks to asset quality from a renewed global slowdown.
However, this is not the stuff of a renewed Global Financial Crisis which some share prices imply and the risks are not uniform.
In addition, whilst there are risks to net interest income from sustained low interest rates the materiality with which this impacts individual banks can vary considerably.
Investors need to tread carefully but in our view the upside risks considerably outweigh the downside risks for much of the sector.
1. Supplement to Bank of England Financial Stability Report: The Framework of Capital Requirements for UK Banks↩
2. Basel Committee on Banking Supervision press release 11th January 2016↩
3. Peston Lecture 19th January 2016↩
4. Additional Tier 1 bonds are bonds that share the loss-absorbing characteristics of equities. They are a type of capital that banks can use to satisfy regulatory capital requirements under Basel III.↩
5. EURIBOR: Euro Interbank Offer Rate - The rates offered to prime banks on euro interbank term deposits.↩
6. Return on equity: The amount of net income returned as a percentage of shareholders equity.↩
European Banks Analyst