Mergers & acquisitions: Banks must sell equity or businesses

By:
Peter Lee
Published on:

Eurozone banks still have a way to go in deleveraging, but investor concern over weak disclosure might close access to equity.

Eurozone banks have shrunk their balance sheets by €2.9 trillion since May 2012, but they are still too large for policymakers’ comfort, at €32 trillion (over three times the size of the eurozone economy), according to Alberto Gallo, head of European macro credit research at RBS.

In 2011 the eurozone banks were three-and-a-half times the size of eurozone GDP and Gallo suggests that policymakers won’t rest easy until they are cut down to under three times. He estimates deleveraging isn’t quite halfway complete and that eurozone banks will have to cut €3.2 trillion more in assets over the next three to five years. "Banks have done a lot to adapt to a new regime of higher capital standards, but regulators are also raising the bar, introducing stricter rules and new regulations including the leverage ratio."

Between them the top 11 eurozone banks, which account for 40% of the banking system’s assets, will have to cut €661 billion of assets, mostly by not renewing loans as they mature, and generate €47 billion of capital to comply with upcoming regulatory requirements, Gallo suggests. "The leverage ratio puts more pressure on banks with big derivatives and swaps books to reduce assets," he says.

After 25 years of managing to risk-weighted capital rules, banks aren’t happy with this change to measuring up against nominal leverage standards that might punish banks that have built up large positions in low-risk assets.

Leverage ratio

Deutsche Bank’s chief financial officer Stefan Krause
Deutsche Bank’s chief financial officer Stefan Krause
At Deutsche Bank’s second-quarter results, chief financial officer Stefan Krause hinted darkly at the potential direction of travel. "The leverage ratio obviously fails to assess the quality of the balance sheet as well as the firm’s ability to fund itself," he said. "The leverage ratio, in our view, forces banks to run a very different business, and one of the obvious consequences is the need to originate higher-yielding assets and, by definition, therefore take on more risk. Our average loan-loss provisions have been 20% of those of some of our peers over the past five years because our respective regulatory focus has led us to very different portfolio composition decisions with a focus on higher-quality borrowers."

While investors ponder whether banks asking them for more capital today might throw it into riskier lending in the years ahead, requests are picking up. Last month investors in European banks were still absorbing the news that Barclays will plug a capital shortfall identified by the Bank of England by completing a £5.8 billion ($9 billion) rights issue, issuing a £2 billion additional tier 1 contingent convertible, and shrinking assets by £65 billion to £80 billion so as to achieve a leverage ratio of 3.1% by mid-2014.

This follows the capital-raising by Deutsche Bank at the start of the second quarter that might have ushered in a new phase of adjustment in European banks’ balance sheets.

Although Deutsche appears well on track with its plan to cut costs by €4.5 billion by 2015 and has pushed its Basle III capital ratio up to 10%, analysts now expect more. Kian Abouhossein, analyst at JPMorgan, advocates a further capital-raising to insure the German national champion bank against growing uncertainty over regulation of large investment banks. "Deutsche Bank’s new management should consider additional action in the form of an accelerated bookbuild raising about €3 billion of additional capital today, RWA reduction programme of €60 billion (15%), besides the current [€250 billion] asset reduction plan, and accelerate the cost saving plan," he says.

Expect more bank equity issuance, a further reduction in lending as loans mature and even resurgent M&A activity among banks in the months ahead.

Gallo says: "The equity capital markets are open to large banks that can solve a large proportion of their capital problems by raising equity and might need to raise just €29 billion. The good news is that the large banks are making more earnings in core Europe as non-performing loans are reducing." RBS points to Crédit Agricole as needing to raise €17 billion and Société Générale €6 billion, although this was before Société Générale had added 27 basis points to its Basle III tier 1 capital ratio through a €1.25 billion perpetual subordinated hybrid – a so-called additional tier 1 bond, sold at the end of August, that attracted over €4 billion of demand.

Underperformance

But will the equity capital markets be as accommodating to bank issuers as analysts hope? Abouhossein points out that although the share price reaction to Deutsche’s surprise accelerated bookbuild capital increase back in April was positive, subsequent market focus on leverage, US legal entity subsidarization and new litigation, among other issues, led to material underperformance in the stock, which was one of the poorest performers among large European bank shares and valued Deutsche at a discount of 0.7 times book value compared with 0.9 times for many of its peers at the start of September.