The spread of the coronavirus is resulting in countries across Europe entering “lockdown” with economic activity and daily life on hold for millions of people. This is clearly having an extremely disruptive impact on the banking sector, although the authorities are taking steps to mitigate the worst effects.
In terms of the outlook for banks, much depends on a) how long the period of Covid-19 disruption lasts, and b) the degree of government response. The first point is of course unknown at this stage. However, we have seen myriad government responses announced across Europe: tax payment deferrals, debt moratoria, credit guarantees, etc, to mitigate the effects of the crisis.
We have also seen central banks cutting interest rates, thereby reducing the cost of short-term borrowing.
What is clear is that not all banks will experience the impact in exactly the same way. Some are better positioned than others to weather this crisis and that is why stock selection will be critical when investing in the sector.
Risks are clearly elevated, but we see a low probability of a sector-wide bailout being forced upon shareholders.
Will there be a credit crunch in Europe?
The most material impact of the crisis on banks is likely to be higher credit losses. Many European governments have launched credit guarantee schemes which we consider vital to ensure that there is no credit crunch. These schemes will flatten (but not fully offset) the impact of the downturn on credit losses; a typical structure is for the bank to take c.20% of the loss and the government c.80%.
Government-driven forbearance measures (e.g. offering mortgage holidays) will also lower likely credit loss charges. (A credit loss charge is an expense booked in a bank’s profit and loss account to reflect the risk that the bank will not be paid back in full by a borrower; today’s accounting standards require this charge to reflect both actual defaults on loans as well as a forward looking charge against performing loans)
Risks of a protracted downturn
The longer and deeper the downturn, the greater the risk that bank earnings and capital are impacted. At this stage, certain sectors appear more at risk than others (e.g. oil & gas, aviation, travel, leisure and some retail).
In practice, asset quality deterioration is likely to be more broad-based. In addition, accounting rules (specifically IFRS 9) have the potential to “front load” losses (because losses are now calculated as expected rather than incurred).
We would not be surprised to see some form of additional regulatory forbearance here if the period of disruption morphs from weeks into months. The sensitivity of banks’ earnings and capital to higher credit loss charges varies substantially. It is a key factor we take into account when considering stocks in which to invest.
Clearly, the revenue environment has also deteriorated. In the near term, fee and trading income is likely to come under more pressure than net interest income. (See end of piece for a definition of these terms).
Once we see a recovery, these lines (certainly fee income) will bounce back quickly. Net interest income is more annuity-like and so will be more resilient in the near-term. However, over the longer term, lower interest rates will continue to erode margins.
Again, there is a material divergence in impact across the sector. We would highlight Nordic banks as being more resilient here, in part because they have a greater ability to reprice back book loans. Eurozone and UK banks are potentially more vulnerable.
It is important to note that fundamentally the impact on share prices from higher credit losses should not be the same as the impact from lower revenues. Abnormally large credit loss hits should be considered 1x price-to-earnings events, while net interest income pressures will depress mid-term return on tangible equity, and therefore fair values.
A sustained downturn has the potential to force weaker banks to cancel dividends and ultimately to raise capital. The announced relaxation of capital buffers by central banks across Europe is important in buying the banks some time, but we would expect that capital levels would at some point have to be rebuilt.
For some banks this would imply a deterioration in their capacity to pay dividends and/or an increase in the share count. This is another factor that makes stockpicking so important.
Could the European bank sector experience a rebound?
So far, government and central bank intervention has done little to assuage market fears. The only “silver bullet” is a vaccine or cure which is some months off.
The MSCI Europe index has returned -33.7% year-to-date with the banks sub-index returning -43.5% (source: FactSet, as of 19 March).
However, much of the pressure stems from the nature of the government response to Covid-19, rather than the virus itself. At present no government has a clear exit strategy but it would be surprising for such widespread shut-downs to be maintained into the medium-term as this would be socially and economically untenable.
If disruption is measured in weeks rather than months then the sector has the potential to rebound very materially. With effective government and central bank action, the impact on 2021 or 2022 earnings could end up being significantly smaller than the share price declines we have seen.
In terms of valuation, the European banking sector trades on a 2021 price-to-earnings ratio of just 6x, compared to the 10-year average forward price-to-earnings ratio of 9.4x. And there is close to a 10% dividend yield on top.
And what could cause further declines?
The biggest risk is a protracted downturn with the current situation persisting into the medium-term. This would likely mean that many banks would become loss-making.
However, at current valuation levels the market is already assuming a reasonable probability that this is the outcome.
Banks in better health now than in 2008
It is important to note that Europe’s banks enter this crisis in better health than at the start of the 2008/9 Global Financial Crisis. Banks have strong levels of capitalisation, strong liquidity buffers, are now seeing a loosening rather than tightening of regulatory requirements, and are the conduit of government support for impacted businesses and individuals.
In our view, the risk that share prices collapse much further, with a forced sector-wide recapitalisation imposed on shareholders, feels low.
Fee income is the money banks earn from banking activities such as payments, loan arrangement or late payment as well as non-banking activities such as insurance or wealth management.
Trading income is revenue from trading financial instruments.
Net interest income refers to the spread between interest earned from loans and other interest earning assets such as bonds and the interest paid for deposits and other funding costs.