After half a decade of banking crisis, some measure of stability appears to have returned to the sector. Last month, 278 of Europe's banks repaid €137bn-worth (£119bn) of loans to the European Central Bank (ECB) - a move that looked impossible as recently as last summer. Those funds formed part of the €1 trillion of emergency liquidity that has been provided by the ECB to around 800 banks since December 2011 as part of its Long Term Refinancing Operation (LTRO) - funds perceived as essential to safeguard the banks as the eurozone's debt crisis emerged in earnest during 2011.
"The foundation of a bank's health, namely its ability to 'self fund', has returned for European banks," point out banking analysts at Espirito Santo Investment Bank. "Banks are using the improved normalcy in the wholesale markets to wean themselves off their heavy subscriptions to LTRO funds."
That improved funding backdrop reflects the ECB's decision in September to do "whatever it takes" to save the euro - through the purchase of as much sovereign debt in the secondary market as needed to generate confidence. That "has gone a long way to alleviating (albeit not fully removing) the systemic tail risk of a eurozone break up," observes Espirito Santo. "Banks are now operating in an environment close to what can be considered 'normal' after the turmoil of the past 18 months."
From a share price perspective, this ECB-induced stability has been a game-changer - the FTSE 350 banks index, for example, has risen nearly 50 per cent since 1 June. But just because collapse has apparently been averted, it doesn't automatically follow that banks' prospects have improved - far from it.
No signs of growth
The biggest threat remains the weak economic backdrop. The UK's economy contracted 0.3 per cent in 2012's final quarter and prospects going forward look bleak. The IMF expects the UK economy to grow just 1.1 per cent in 2013 and the eurozone a mere 0.2 per cent, with Italy and Spain set to remain mired in recession. The trouble is that such weak economic conditions, as analysts at Berenberg Bank point out, "means higher loans losses, deterring banks from lending".
There's also a problem with credit demand. Not only does it inevitably slide in times of economic downturn, but the world is already heavily indebted - the debt burden of the western economies has never been higher. So, unlike after past downturns, demand for credit is already looking satisfied to a large extent. "High levels of debt would suggest that demand has been maxed out," reckons Berenberg Bank. "The deleveraging phase of the debt cycle can last up to 35 years (eg, the UK 1945-80). Thus we expect anaemic growth to be a multi-decade event." If that's the case, investors should expect the banks to struggle for far longer than they traditionally have following recessions.
Reputations and regulations
The banks are still tackling a long list of self-inflicted wounds, too - in the form of reputational issues. The resulting compensation payouts are the biggest near-term cost facing the sector - at least in the UK - with the latest hit looking set to come from the mis-selling of interest rate swap products. Last month, the FSA announced that over 90 per cent of sales reviewed had failed to comply with one or more regulatory requirements. Sector analysts, however, do not think the costs here will spiral as they have done with the payment protection insurance (PPI) mis-selling saga. So far, the UK's banks have set aside about £11bn to cover PPI compensation costs, with
Fines for various misdemeanours are another problem.
A heavy regulatory agenda is another headwind. Quite apart from Basel III's tough capital requirements, there's an array of other regulatory proposals which, if implemented, will carry big costs. Of particular significance is the EU's Liikanen Review which, like the UK's Vickers report, proposes some degree of separation between retail and investment bank-type activities. Regulatory change is also raising the worry that capital ratios may not be as healthy as they seem - possibly meaning some combination of fund raisings, reduced dividends and less lending. That reflects the possible impact of such proposals as the harmonisation of the risk weightings that are applied to loans - these often vary substantially between banks. Other threats include plans to review capital requirements for trading activities, or the enforcement of capital and funding subsidiarisation rules - meaning operations such as overseas bank branches would need to be separately capitalised.
Europe at a glance
Against such a backdrop, investors should brace themselves for bad news from the impending full-year reporting season.
UK sector view
The UK's banks are just as exposed to the hefty regulatory agenda and the weak economic backdrop as their European peers, leaving few reasons to buy their shares. Yet today's more stable conditions also make the sell case less compelling. Indeed, our sell tips on Barclays (279p, 26 May 2011), RBS (226p, 9 Aug 2012),
That's not to say the four don't face challenges. Barclays is still repairing its reputation - this month it announced the departure of finance director Chris Lucas and group general counsel Mark Harding, as the bank removes management connected to past scandals. Plans to scale back the investment bank carry risks, too - it will leave Barclays even more exposed to weak retail banking conditions. And, while HSBC's Asian operations offer comfort, the bank still faces credit quality concerns in North America. Meanwhile, Investec expects Lloyds and RBS to reveal full-year pre-tax losses of £1.43bn and £3.38bn, respectively - with no dividends, possibly, for years. Still, as long as the ECB continues to intervene, it's hard to see the share price gains of recent months being lost and we move to hold recommendations for all four.
Standard Chartered's Asian growth story leaves it as our favoured UK bank - yet, with its shares trading at a punchy multiple of tangible net assets, we're still merely holders. For a bank worth buying, we reiterate our tip (Sfr12.6, 26 Jan 2012) on Swiss lender
With the Spanish economy deep in recession, and with the property market collapse still hitting Spain's banks hard, we reiterate our sell advice (533p, 10 Feb 2012) on Santander.
THE BROKER'S VIEW: The illusion of stability
For the banks, a good analogy for ECB support is that of a patient connected to a life support machine - it will keep the patient breathing but, switch it off, and that patient will quickly expire. In short, bank prospects could be bleak once the authorities finally withdraw.
Certainly, ECB interventions have meant falling funding costs and, for now, less chance of a eurozone sovereign default. However, not only must such support come to an end eventually, but it's also allowing banks to avoid addressing such fundamental structural problems as asset quality, overly generous risk weightings or capital adequacy - longer-term issues that must be addressed if the banks are to function properly again. Accordingly, the more normal banking conditions that seem to have descended for now are, ultimately, illusory.
Even against the background of that manufactured stability, banks face headwinds. Economic conditions remain tough and the impact from a host of reputational issues such as PPI and interest rate swap mis-selling significant. Indeed, Libor manipulation could even generate hefty tobacco industry-style civil litigation claims lasting many years.
In the nearer term, bank newsflow is likely to be uninspiring rather than disastrous. With the forthcoming full-year results season, volumes will probably be lacklustre with some margin improvements - reflecting lower funding costs. There could be modest progress on credit quality, too, although it's unclear whether that will prove sustainable.
In the UK, we have outperform recommendations on both internationally focused banks - Standard Chartered and HSBC. Standard's shares are expensive and earnings growth could be better given its focus on emerging markets. But there should eventually be a good cost-cutting story there. HSBC, meanwhile, has strong restructuring potential and decent exposure to Asia and the US.
But we have sell recommendations on Barclays, Lloyds and RBS. Barclays looks under-provided for in Spain and its investment banking operation is a big earner for the group - restructuring there will be difficult. Provisioning levels at both Lloyds' mortgage book and the commercial real estate book at RBS look too low.
Ed Firth is Head of European Banks Research at Macquarie Securities