The Value Perspective

Credit where it is due

Kevin Murphy

15 Jun 2012

Credit spreads for European banks are close to their all-time highs or, to use the language of the credit analysts, ‘wides’ – in other words, the prices at which the bonds of the banking sector are trading compared with non-bank bonds envisage a very pessimistic scenario indeed.

Concerns about the macroeconomic environment, the eurozone crisis and especially the fate of peripheral Europe have essentially led the bond market to overlook some fundamental improvements in capital and liquidity within the banking sector and this has put pressure on asset quality and forced credit spreads wide open.

There are of course no guarantees any bank will make you money in the short term as their share prices are extremely volatile and subject to macroeconomic fluctuations that are beyond anyone’s control or even predictions. Nevertheless, we would argue this blanket view of the sector is, on a three to five-year view, unfair to certain businesses – and specifically to Lloyds and Royal Bank of Scotland (RBS).

There are a number of reasons why these two businesses look attractive, the first of which is their high capital ratios. With Northern Rock running into trouble in 2007, Lehman Brothers failing a year later and Lloyds and RBS themselves receiving injections of government money in 2009, UK banks have been building up their capital buffers for some time now. Indeed Lloyds and RBS are, according to independent credit analysts at Barclays, now among the five best-capitalised banks in Europe.

Furthermore, measuring liquidity by ‘liquidity reserve coverage’ – put simply, how much money a bank must pay back in the short term compared with how much cash it has in reserve to do so – the pair are also two of Europe’s best-funded banks. The Barclays analysts have calculated that, in the first quarter of this year, Lloyds’ and RBS’s liquidity reserve coverage was respectively 245% and 191%, which compares with a sector average of 142%.

Meanwhile, as we have noted before in articles such as A tale of two businesses and In the right direction, the pair’s exposure to the sovereign debt of peripheral Europe is negligible. Lloyds currently has none of its equity base exposed to the government and central bank debt of Greece, Ireland and Portugal and a grand total of £13m to Italy and £15m to Spain while RBS has a sum of £446m exposed to the sovereign debt of those five countries, which amounts to just 1% of its equity base.

Granted, sovereign exposure is much higher at a variety of other banks across Europe, which means the possibility of some kind of contagion effect can never be dismissed. However, in terms of direct exposures, the UK banks have increased their capital buffers, enhanced their liquidity and have minimal exposure to the peripheral sovereigns. This suggests that although their credit spreads remain near those all-time ‘wides’, they deserve to trade more narrowly than they have in the past – and certainly more narrowly than some of their competitors.

This is not just the view of The Value Perspective – the Barclays credit analysts recently noted: “First-quarter earnings highlighted the differentiated fundamental trend of UK banks and, in particular, RBS and Lloyds. Aided by the deleveraging process that both banks have embarked upon, core capital ratios are sound, at around 11%, wholesale funding reliance continues to decline quarter after quarter and liquidity reserves remain adequate.

“More importantly, past asset quality pressures appear to be easing and although non-performing loan ratios remain high – 10.1% for Lloyds, 9.4% for RBS – a sustained inflexion point in non-performing loan formation appears within reach. We also note that peripheral sovereign exposures at both RBS and Lloyds continue to be immaterial, at less than 2% of core capital.”

The market has a habit of shooting first and asking questions later but the general point here is the UK banks are much further through the process of overhauling their businesses than their continental counterparts – they have safer balance sheets, they have turned the corner in terms of asset quality and their peripheral exposure is less concerning. As such, the prices of the bonds – and by implications also the equity, which is trading at around half book value – are probably too cheap on a three year-view.

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