Many investors have been pleasantly surprised by the recent relatively upbeat economic news out of Europe, as Q2 GDP growth came in at 0.3% q/q which is the first positive Euro area GDP number since Q3 2011.1 Some investors have expressed interest in gaining exposure to the sectors that are most levered to European domestic growth. This has led to renewed interest in European banks, as reflected by recent investor surveys2 and anecdotal evidence.
However, European banks should not be considered a universal long. There has been tremendous differentiation in the way European banks have adjusted to a world with less leverage, lower growth, and a new regulatory regime encouraging better capitalization of banks and a more integrated EU oversight system. The speed of recovery has been decisively uneven. There are banks that are “over the hump,” meaning that they have made much progress in terms of fixing their balance sheets and improving their capital levels, and are now starting to see profitability return. Eventually these banks should be able to reinstate/increase dividends and meaningfully improve return on tangible common equity (RoTCE). There are other banks that we consider to be just at the foothills of their recovery – they may not be building any book value yet as non-performing loans (NPLs) and other factors are eroding any increase in capital, and profitability continues to be poor. Many of these weaker banks are still heavily dependent on public funding (e.g., LTRO3), and may continue to struggle as they transition back to private market financing. This is generally speaking a North/South divide, although there are exceptions. Furthermore, some banks are in such poor shape that it may take years for them to work through their challenges, and they will continue to be dependent on some form of government help for the foreseeable future. Valuations do not necessarily reflect these differentials correctly given differences in forward-looking assumptions and other factors. For example, some of the stronger banks trade at 0.7x price to tangible common equity (P/TCE)42014e with RoTCE 2014e of 8-10% versus weaker banks which trade at ~1x P/TCE 2014e with RoTCE 2014e of <6%. Over time we expect these valuations to correct as the market further digests the individual conditions of the banks.
European Banks: Dispersion in Valuation and Return Multiples*
Source: Factset, PAAMCO manager estimates
*Equity prices are as of August 28, 2013. Estimates for R (return) and TCE (tangible common equity) are based on the 2014 calendar year.
Continued Fragmentation and Differentiation Expected
Ultimately what investors are looking for is a return of capital to shareholders. Increased confidence around return of capital is generated by improving profitability and/or payout trends. Two factors that are crucial to the development of these trends and that will therefore continue to drive fragmentation among European banks are regulatory/political pressures and the evolution of funding costs as banks continue to move towards private market funding. These two factors are somewhat interconnected, yet also stand on their own. Regulation motivates banks to take action, which drives differentiated results as banks either succeed, fail or delay. The relative success in adapting to new regulation can impact a bank’s credit risk profile, and ultimately a bank’s funding costs (which in turn drives profitability and return of capital expectations). In the end, regulation is government-imposed while a bank’s funding costs are, at least in theory, market-imposed by non-regulatory factors such as sovereign spreads and competition. However, in reality, central bank intervention has had a large impact on bank funding costs over the past several years: as costs rose to unsustainable levels during the height of the sovereign debt crisis of 2011/2012, the ECB implemented various liquidity programs (e.g., LTRO) which significantly lowered funding costs for banks across the board. These steps were necessary to prevent a catastrophic collapse and bought periphery banks time to strengthen their operations and balance sheets. But these “special” liquidity programs are not expected to last forever. Eventually, as all banks go back to private funding, the market will impose higher costs on banks that are considered to have a higher risk profile.
The banking sector is facing what seems to be a permanent revolution in regulation. In addition to national regulatory pressures,5 international and EU-wide regulatory pressures continue to have a strong impact on banks’ health and ultimately stock performance.
- International: At the international level the Basel 3 regulatory framework has impacted bank restructuring efforts over the past few years, forcing banks to increase capital ratios, such as the Common Equity Tier 1 (CET1) ratio, to specific levels by set dates. Although many banks are well on track to achieve Basel 3 minimums with reasonable cushions, there is also a significant number of banks that are not close to these desired ratios and will need to take action to meet the Basel 3 targets. Moreover, even for banks that are on track to reach Basel 3 ratios, with the recent shift in focus to leverage levels (i.e., a “simpler” measure of equity capital to assets that excludes risk-weighting), weaknesses for some of these “leaders” may be exposed after all (and strengths highlighted for others).6
- EU-wide: The credit and sovereign debt crises of 2008/2009 and 2011/2012 drove a great deal of the fragmentation within the EU banking sector. Since then, significant efforts have been made by politicians and regulators to break the feedback loop between the sovereign and national banking systems, establish common rules, and insulate the system from shocks. Although progress has been made, there is still much to do on the road to a true banking union.7As steps towards the creation of a banking union are taken, differentiation will continue as banks’ strengths/weaknesses are exposed. For example, in the run up to the establishment of the Single Supervisory Mechanism (SSM),8 the ECB will conduct stress tests on the back of an Asset Quality Review (AQR), which will undoubtedly highlight weaknesses.9
Funding Costs and Other Idiosyncratic Issues
Investors will continue to favor banks whose restructuring efforts are viewed positively in terms of capital ratios, improvements in asset quality and profitability trends. There are banks whose profitability is improving considerably on the back of reduced funding costs as they repay LTRO funds. On the other hand there are banks that continue to post losses and whose outlook continues to deteriorate based on contracting margins, shrinking loan books and asset impairments, while remaining dependent on “cheap” ECB funding. As they are forced to fund themselves through private markets, increased funding costs will impact profitability. For example, a bank whose wholesale borrowing cost rises by 100bps could take a 3% hit to RoTCE (e.g., if wholesale funding is ~20% of the balance sheet, then the pre-tax hit would be approximately 20bps, and 15bps after-tax, which when multiplied by a 20x leverage ratio is 300bps). Clearly, financial fragmentation is creating opportunities for longs and shorts.
A Wild Ride, but Worth It
The European banking sector is particularly vulnerable to short-term mispricing for three key reasons:
- There is a multitude of economic, political, regulatory, sector-specific and corporate factors that impact the outlook for a bank.
- The banking sector has played a central role in economic/sovereign/financial crises in recent years, and the market has tended to prematurely trade on headlines rather than fully digesting new information. Alternatively, when complex new information has come out, such as on the regulatory front, the market can be unusually slow to respond.
- Many periphery banks in Europe have ownership characteristics that tend to exacerbate short term mispricing, including reduced free float due to government ownership, heightened Treasury trading, and relatively heavy retail ownership.
Although over time correct investment calls should be rewarded (e.g., the difference between the average 1-year return of the top 10 performers from August 2012–July 2013 and the average of the bottom 10 performers was a staggering 103%), investors in European banks must realize it can be a wild ride with months that will show positive performance on both longs and shorts while others will disappoint when technicals dominate or political intervention significantly delays the fundamental thesis. Given this volatility, investing in European banks warrants close monitoring, active trading and portfolios that incorporate both equity and credit exposure. Credit investments can add some stability to the portfolio (given current income) as well as a diversifying return stream.
1 Barclays: “Don’t Get Carried Away”, Economics Research. August 16, 2013.
2 For example, Bank of America Merrill Lynch: “Summer Surge”, European Fund Manager Survey. August 13, 2013.
3 Long Term Refinancing Operations (LTRO) is one of the ECB’s liquidity provision programs. The most recent iteration of the LTROs, announced in December 2011 and February 2012, provided three-year loans (rather than one or less, as was more typical in previous LTRO programs).
4 Price to Tangible Common Equity (P/TCE) is a frequently used valuation ratio for banks.
5 There are many examples of national policy/regulatory actions that impact national banking sectors positively/negatively and affect some banks more than others (i.e., the Bank of Spain’s May 2013 publishing of new guidance for reclassifying restructured loans).
6 For example, although UBS looks strong from a Basel 3 CET1 basis, it is towards the bottom of the list in the leverage ratio ranking.
7 For example, the potential establishment of an EU-wide resolution mechanism and common deposit scheme are important steps on the way to forming a true banking union.
8 The SSM is the mechanism through which the European Central Bank will assume responsibility for specific supervisory tasks related to European banks and financial stability.
9 For example, Portuguese, Spanish and Italian banks are particularly exposed to any potential fall-out from “real” stress tests, given the degree of growth in NPLs and relatively low loan loss reserves. In fact, Barclays estimates that Portuguese banks may require an additional ~€5-12B in capital as bad loans and losses continue to erode capital buffers. Barclays: “Capital Shortfall in Portugal”, European Banks. August 14, 2013.
Melanie Rijkenberg, CFA, CQF is an Associate Director working in Portfolio Management. She focuses on European capital markets and manager research and is responsible for certain institutional client relationships.
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