Europe's banks: cause for concern or cause for buying?
Most banks are in better financial health
Justin Bisseker, European Banks Analyst, says:
"The good news is that banks across Europe are generally much stronger than they were in the lead-up to the financial crisis. This is due in large part to regulators who have required banks to hold more capital to guard against the risks posed by a potential future crisis. Importantly, regulators have also been more prudent in terms of how that capital is calculated.
"The chart below indicates that the average core tier 1 ratio for banks – a key measure of banks’ capital – has more than doubled in the years since the global financial crisis. This is positive in ensuring history does not repeat itself. However, it is an enormous challenge for the cohort of banks who have as yet been unable to adjust their business models fast enough to generate above cost of equity returns on this enlarged buffer.
"In our view, an increasingly large cohort of banks are becoming overcapitalised and this should support the current healthy dividend pay-outs as well as share buybacks. That said, there are sizeable differences between countries and jurisdictions (Nordics versus eurozone in particular). The remaining risks will centre around profitability and non-performing loan issues in Italy and parts of southern Europe, and also emerging market exposures (which generally has a greater impact on earnings than on capital).
"Meanwhile, the ultra-low interest rates that were introduced in the wake of the global financial crisis were also problematic for the sector. This meant that the interest rate banks were able to earn on their loans was pushed down, but they couldn’t reduce how much they paid for deposits by the same amount because depositers wouldn’t countenance a negative rate of interest.
"Our approach is to favour banks which can deliver attractive returns whatever the rate environment. Higher European Central Bank rates would be a meaningful positive for the sector. Our own estimates are that 100 basis point higher interest rates would improve pan-Europe bank sector earnings by some 16%, with the eurozone subsector benefiting some 17%.
"Italy has been a source of worry for markets over the summer as budget negotiations begin. Much hinges on the policies to be implemented by the new government and whether a higher risk premium is demanded in Italy as a result. Higher sovereign borrowing costs could impact net interest margins as Italian banks struggle to pass higher funding costs onto borrowers. There are also concerns that banking union plans could stall amid Italian populism. However, absent a renewed economic downturn, the formation of non-performing exposures in Italy looks well past its peak with the resulting lower credit loss charges an important fillip to earnings generation.
- For more on Italy, see Why Italian politics matters for eurozone banks
"Another recent concern is currency volatility in some emerging markets. This will dampen earnings momentum for the handful of banks impacted, but the impact on capital will be limited.
"Is it all doom and gloom in the banking sector? Not at all. The pan-European banking sector is more diverse today than ever before in terms of earnings security, capital generation, capital adequacy, dividend-paying capacity and asset quality risk. That should equate to attractive stockpicking opportunities as we await a broader re-rating as central bank policy tightens further by 2020."
Navigating a nuanced picture
James Sym, Fund Manager, European Equities, says:
"One concern we have for the market in general is the increasing number of companies suffering from rising costs, especially wage inflation. This has profound implications as inflation has not been a concern for most companies for a decade or so. How might this more inflationary environment impact the banks? There are a number of considerations.
"As a first-round effect, we think this phenomenon is likely to be negative for many companies as it makes their earnings expectations look overly optimistic, because analysts are expecting an overall profit margin expansion which may not come to pass. Banks are unlikely to be immune from this.
"Secondly, there is clearly a direct impact on banks themselves. A typical wage bill is around 35% of sales for a bank so a 10% increase in wages is a headwind of 3.5% of revenues. We performed this analysis bank-by-bank and assessed the profit impact. Our conclusion is that as investors we should stick with the more profitable, simple, retail banks. Interestingly, as capital-intensive businesses we found banks are less vulnerable than the market as a whole, by more than 10%, despite their lower return. The table below shows a selection of the results from the 40 or so banks we analysed.
"Finally, higher inflation is likely to lead to higher bond yields as monetary policy changes. All else being equal, this improves the margin banks make on each loan. However, at a certain level, corporate and household cashflows become squeezed and defaults rise, although we wouldn’t expect this to be material until interest rates reach a certain level, perhaps at 1-2% higher than today. Last but not least, higher inflation and bond yields are classically an end-of-cycle phenomenon.
"So it’s a nuanced picture for the sector as inflation returns: initially positive but becoming negative over time. Added to these considerations is our view of valuations, which are not as cheap as they were a few years ago. We have a clear preference for higher quality banks that are less exposed to the headwinds of this new inflationary environment but can still benefit from the opportunities that it presents."
Staying alert to the changing opportunity set
Martin Skanberg, Fund Manager, European Equities, says:
"In 2017 the combination of synchronised global growth and a benign political backdrop in Europe was positive for the banking sector. In particular, this was a tailwind for some of the region’s more lowly-valued banks. We are always on the look-out for mispriced opportunities and we saw one emerge as southern European lenders outperformed their Nordic counterparts.
"The Nordic banks usually trade at a substantial premium to the European banks sector but spring 2018 saw them trading in line in valuation terms. This is highly unusual given the Nordic banks are high quality, safe businesses with good track records of shareholder returns. We therefore saw an opportunity to switch out of a holding in an Italian bank and into what we viewed as the most attractive opportunity in the Nordic region.
"We would continue to highlight the importance of being selective in the European banking sector, and of being alert to new opportunities as they emerge. Individual banks differ dramatically; for example, the largest Spanish banks have long been overvalued, in our view, and also have significant exposure to certain emerging markets which entails additional risks. As ever, thorough analysis is needed to understand what the share price is implying about any given company, and what might change to make the market value that company more highly."
European banks still a difficult proposition for global investors
Andre Reichel, Global Sector Specialist, Global Equities, says:
"European banks have made significant progress since the last crisis, but from a global perspective, a large part of the landscape still remains a work in progress.
"There are two key reasons for this. Economically, most of Europe remains fragmented, with too few of the co-ordinated reform programmes needed to sustainably increase wealth and drive demand for banking products. Politically, European banks also still lack a level playing field. Both aspects impact large parts of the European banking system in a negative way.
"The first problem directly obstructs stronger loan growth and indirectly leads to lower interest rates. Compared to that, growth and margins in North America, Asia and some emerging markets (EM) is higher, leading to strong book value and earnings growth.
"The second issue comes from the conundrum that Europe wants to be a union, but still applies different laws and restrictions on financial services in different countries. The creation of a banking union would help to establish a more level playing field for Europe’s banks across large parts of the continent. This would allow services to be delivered at lower costs, and it would introduce effective competition. In turn, this would benefit better managers and better franchises, who could cost-effectively take more market share. The absence and slow progress towards this also explains why European banks are lagging so much in profitability to their North American, EM and Asian peers."
 This is the ratio of a bank's core tier 1 capital – its tangible equity adjusted for certain items such as tax loss carry forwards and minority excess capital held within subsidiaries – to its total risk-weighted assets. It is a key measure of a bank's financial strength that has been adopted as part of the Basel III Accord on bank regulation.
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