European banks: why investors should still be choosy even as prospects brighten

Bank shares have been supported by expectations of higher interest rates but these could take some time to materialise. We prefer banks that are less reliant on the rate backdrop and note UK banks look attractive for patient investors.

12 July 2017

Justin Bisseker

Justin Bisseker

European Banks Analyst

We remain selectively constructive on the pan-European banking sector.

Capital levels and bank profitability continue to build, the global economy is strengthening and, at least in the US, interest rates are rising with the hope that Europe and even the UK could follow.

Regulatory headwinds are abating (with the potential that they may even turn into tailwinds, led by the US) and geopolitical risks feel diminished.

Higher rates still some way off

The “rising tide” of the global reflation1 trade has lifted much of the sector over the past year. One has to be conscious that this could abate should higher rate expectations get pushed out.

Furthermore, investors need to understand that the impact of the withdrawal of monetary stimulus on many of Europe’s banks, as and when it arrives, will be rather more nuanced than commonly assumed.

For euro area banks in particular, higher interest rate expectations have been a key driver of positive share price performance over the past year. However, core inflation remains subdued and wage growth muted despite strengthening GDP and falling unemployment.

There is therefore a risk that interest rates could remain at extremely low levels for many years to come, even as the economy strengthens.

Preference for those banks not reliant on rate rises

Our approach is to favour banks which have the potential to deliver attractive returns whatever the rate environment. The speed at which banks can reprice their balance sheets and adapt their cost bases varies markedly across Europe.

For many banks, the anticipated earnings boost from higher interest rates stems in large part from the transitory benefit of subsidised European Central Bank (ECB) funding via TLTRO2 (targeted longer-term refinancing operations).

Meanwhile, the higher long-term rates which would accompany ECB tapering will prove negative for profit margins and capital. This will come as term funding costs rise and as the value of bonds held on bank balance sheets falls.

As and when the ECB chooses to roll back the comfort blanket of monetary accommodation, such details will matter.

A few banks still need balance sheet clean-up

The banking sector is far from uniform. Most banks in the pan-European universe have relatively clean balance sheets, but some – in Italy and Spain in particular – have more work to do.

Furthermore, the profitability of banks – even on an assumption of normalised credit losses – varies markedly, as does the predictability of earnings.

The majority of banks have now rebuilt capital to levels which incorporate a reasonable buffer against the unexpected. However, the capacity of banks to continue to build capital - and so fund growth, pay dividends, absorb unanticipated shocks and accommodate regulatory pressure - varies markedly.

A small but awkward cohort of banks still needs material further restructuring efforts to lift profitability to levels where value is no longer destroyed.

ECB may increase scrutiny

As the recent failures of Banco Popular in Spain and Veneto Banca and Banca Popolare di Vicenza in Italy demonstrate, this remains a sector where investors need to tread carefully. When large underprovided problem loan balances collide with an inadequate capital base, both equity investors and bondholders are at risk of material loss.

Thankfully, the number of problematic banks continues to diminish. Nonetheless, we see a very high chance that the ECB steps up both the intensity of its scrutiny of provisioning adequacy and the pace of required balance sheet clean up.

This would likely be to the detriment of earnings and possibly share count for a minority of Europe’s quoted banks.

Rewards may outweigh risks in the UK

Meanwhile, in the UK, the equity market seems to be applying an ever higher risk premium to UK domestic banks. A weakened government, slackening GDP, high consumer indebtedness and Brexit-related uncertainties present an unpalatable cocktail of concerns.

To be sure, there are risks, but part of our job as investors is to judge when the potential rewards more than justify those risks.

The fact that the Bank of England’s Financial Policy Committee has signalled that it expects to increase the countercyclical buffer2 to 1% by November next year (seen as the appropriate level for a “standard risk environment”) should offer some degree of comfort for investors.

With domestic UK banks all screening comfortably at the cheaper end of the sector, we believe there is a high chance that patience could be well-rewarded.

1. Reflation is a fiscal or monetary policy designed to expand a country's output, seeking to bring the economy back up to the long-term trend after periods of stagnation or contraction.

2. A countercyclical capital buffer is intended to protect the banking sector against losses. Banks are required to add capital at times when credit is growing rapidly so that the buffer can be reduced when the economic cycle turns.

Important Information: This communication is marketing material. The views and opinions contained herein are those of the author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. It is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a reliable indicator of future results. The value of an investment can go down as well as up and is not guaranteed. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Schroders has to its customers under any regulatory system. Regions/ sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this material include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change.  To the extent that you are in North America, this content is issued by Schroder Investment Management North America Inc., an indirect wholly owned subsidiary of Schroders plc and SEC registered adviser providing asset management products and services to clients in the US and Canada. For all other users, this content is issued by Schroder Investment Management Limited, 1 London Wall Place, London EC2Y 5AU. Registered No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.