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Headwinds plague Europe’s banks

Overall, economic recovery in Europe is still looking pretty weak and that's making it tough going for the continent's banks
June 6, 2014

The bull case for Europe’s banks - like banks everywhere - will always significantly reflect economic conditions. A booming economy drives demand for credit, keeps defaults low and bolsters bank earnings. But economic conditions in Europe remain mixed. Sure, recovery in some countries - the UK and Germany, for instance - looks well entrenched. The IMF thinks the German economy will grow nearly 2 per cent this year, while the UK’s is expected to expand by almost 3 per cent. But it’s a very different story elsewhere: Italy and Spain, for example, were still in recession last year and only modest growth for both economies is expected in 2014.

Earnings pressure

Overall, therefore, European recovery remains "woefully weak," says banking analyst Matt Spick of Deutsche Bank (De: DBK), with the IMF expecting the eurozone economy to grow by little more than 1 per cent this year. That sluggishness was apparent during a generally underwhelming first quarter reporting season for the banks. "The aggregate earnings momentum of the European banks has - again - been negative over the quarter," observed Mr Spick. Indeed, Deutsche downgraded its earnings estimates for the sector overall by 3.8 per cent in 2014 and 1.3 per cent for 2015.

That’s significantly down to continuing low levels of loan growth, with demand for credit remaining "weaker than expected," according to Berenberg Bank. This is demonstrated by figures released last month from the European Central Bank (ECB). In April, loans to households in the eurozone area were flat year on year, while loans to non-financial corporations dropped 2.7 per cent. That’s driving calls for the ECB to intervene. In an effort to counter the risks of persistently low inflation, the ECB is widely expected to begin cutting interest rates and that could help stimulate demand for credit. But other policies could also be pursued, with credit easing measures - similar to the Bank of England’s funding for lending scheme "becoming increasingly likely" reckons economist Frederik Ducrozet of Crédit Agricole.

 

 

Bad debts

Persistently poor credit quality - partly reflecting emerging market exposure - is also dragging on earnings and Deutsche has revised its aggregate bad debts forecast upwards on the back of first-quarter results. "The more candid [bank bosses] admitted to near-term loan losses remaining high," reports Berenberg after having conducted discussions with 18 bank management teams last month.

There are certainly some painful bad debt issues left to tackle. In Spain, for instance, banks are still wrestling with the legacy issues of the country’s real estate collapse which is contributing to some especially painful looking non-performing loan (NPL) ratios. For example, Banco Popular's (Sp: POP) ratio of NPLs to its loan book reached over 14 per cent in the first quarter, with CaixaBank's (ES: CABK) at over 11 per cent. Even banking giant Santander (Sp: SAN) - which boasts significant exposure outside of Spain - reported an NPL ratio of 5.5 per cent. The legacy of recession is still being felt at Italy’s lenders, too: UniCredit (It: UTG) - the country’s largest bank - revealed a first quarter NPL ratio of more than 8 per cent. Not that UK’s bankers should feel especially smug: RBS's (RBS) NPL ratio, for instance, reached 9 per cent in the first quarter. Compare that to the impressively healthy credit quality at Swiss lender UBS (Ch: UBSN) - where impaired balances stand at a mere 0.4 per cent of the loan book - and it’s clear that credit quality varies significantly around the continent.

 

Investment bank woes

Pressure at Europe’s investment banks is another worry. The trouble is that income from bank’s fixed-income, commodities and currencies (FICC) trading businesses continue to slide sharply; outpacing growth from equity-related business. That’s significantly down to lower trading volumes reflecting such factors as interest rate uncertainty and regulations that limit risk-taking. Barclays (BARC), for instance, saw its FICC-related income slump by 41 per cent at the first quarter stage, while Credit Suisse's (Ch: CSGN) and UBS’s fell 25 per cent and 38 per cent, respectively.

Barclays’ finance director Tushar Morzaria reckons that the FICC market fell about 20 per cent overall during the first quarter, but the business that’s left is too often going to the US banks. For instance, Morgan Stanley's (US: MS) chief financial officer Ruth Porat said that commodities trading had been a "big driver" during the first quarter, while Bank of America's (US: BAC) FICC first quarter revenue declined just 2 per cent year-on-year. It’s unsurprising, then, that many European banks are looking to downsize investment banking. Only last month, Barclays announced plans to axe 7,000 jobs at its investment bank, while UBS has been scaling back here since 2012.

 

Easing capital pressures

There are signs, however, that the regulatory push to bolster capital resources is slowing. "Unlike recent quarters, we did not see uniform capital build [in the first quarter," notes Mr Spick. There might be good reasons for this. As ECB Vice President Vitor Constâncio reported last month, the region’s lenders have already strengthened their balance sheets by €104bn (£85bn) since July from such measures as share sales, asset sales and convertible debt issuances. Indeed, just last month, Deutsche Bank moved to tackle long-running concerns about its financial strength by tapping shareholders for over €8bn: €6.3bn in a rights issue and a further €1.75bn from the Qatari royal family. Basically, banks may not need to raise much more.

Mr Spick now expects a fairly healthy overall Basel III core equity tier one capital ratio (comparing equity to assets, weighted for risk) - or CET1 - for the sector of 11 per cent for 2014, rising to 11.9 per cent in 2015. But whether that’s enough, so that the earnings-absorbing process of building capital can finally be put to rest, depends on the regulators. The European Banking Authority is to stress-test EU lenders’ ability to withstand such calamities as a new recession, a global debt markets sell-off, a rise in funding costs and a collapse in property and equity prices. The results will be known in October. But, before that - and in advance of assuming supervisory responsibilities in November - the ECB is engaged in an asset quality review of the eurozone's largest 128 banks. Banks may have already done enough, but it’s possible that these exercises could reveal further capital and provisioning deficiencies.

IC VIEW:

Europe’s deflationary backdrop could have the effect of increasing the pressure on borrowers and it’s therefore conceivable that the sovereign debt crisis could yet re-emerge: a nightmare for banks. But it’s not likely. The ECB’s willingness to intervene leaves the risk of a return to those grim days of a few years back - when interbank funding markets seized-up on fears of sovereign defaults - looking very low indeed. Still, Europe’s banks face plenty of earnings headwinds: from lacklustre economic growth to persistently high bad debts. Regulatory-driven pressure could also mean that returns on equity never again reach the heady levels seen before the financial crisis. Such factors leave dividend prospects looking fairly uninspiring, too - although not in all cases: yields on French and Spanish bank shares aren’t bad at all. So, even though European bank shares aren’t historically pricey (compared to tangible book values), they’re still best avoided: we prefer the US banks.

FAVOURITES:

If you want quality, think Switzerland and our top pick is UBS. It’s one the world’s best capitalised big banks, credit quality is excellent and first-quarter figures beat analysts' expectations. Yet its shares trade on a similar multiple of forecast tangible book value to those of arguably less robust players such as Lloyds (LLOY). We reiterate our long-standing buy tip (SFr 11.99, 26 January 2012).

OUTSIDERS:

Avoid RBS: it’s still tackling an enormous pre-financial crisis bad debt legacy, doesn’t pay dividends and is likely to remain virtually state-owned for years. Also, be wary of Deutsche Bank. The recent fundraising bolsters its capital strength, but the lender's determination to stick with a universal bank model - at a time when many rivals are downsizing their investment banks - raises doubts.

Key European bank metrics
BankShare price (€)Adj. forward PE ratio*Price/tangible book value*Dividend yield*Basel III CET1 (capital) ratio*
GERMANY
Deutsche Bank†29.649.30.662.5%10.9%
Commerzbank11.6226.90.52nil9.5%
Country average-23.60.60.90%9.7%
FRANCE
BNP Paribas50.2110.933.8%10.6%
Crédit Agricole11.410.10.953.7%9.5%
Société Générale 42.39.70.833.5%10.7%
Country average-10.40.913.7%10.4%
ITALY
UniCredit6.419.20.791.8%10.6%
Banca Monte dei Paschi di Siena23.9na0.25nil10.4%
Banco Popolare13.81410.57nil10.2%
Intesa Sanpaolo2.516.10.912.5%12.6%
Country average-18.10.762.0%11.1%
SPAIN
Banco Santander7.5161.888.2%9.0%
BBVA9.420.21.324.7%10.3%
CaixaBank4.531.81.14.2%12.3%
Country average-19.41.445.5%10.1%
SWITZERLAND
UBS18.313.81.62.8%14.0%
Credit Suisse26.69.71.163.1%11.1%
Country average-121.472.8%12.6%
*Deutsche Bank's estimates for 2014
†Reflects JP Morgan Cazenove's estimate for 2014