Is it different this time for Europe’s banks?
It seems difficult to convince investors that higher bank profits are sustainable.
As much of the world enters a recession in 2023, Europe, with its proximity to Ukraine, is in a worse place than the US. For European banks, however, this could another chance to show just how much they’ve changed since 2008.
Last year, banks in the Stoxx index performed slightly better than the broader European market, which fell 12%. However, despite all the hope for a recovery in banking due to an end to negative rates and the shift from growth to value stocks, regional banks’ share prices still fell 7% in 2022.
Banks in Europe have enjoyed seven consecutive quarters of better-than-expected earnings, according to Morgan Stanley. Yet at the beginning of 2023, they were still trading at a discount of 0.9x book value, according to Citi, against an expected return on tangible equity of 12%.
Investors could be forgiven for taking little comfort from the strength the sector exhibited after the Covid-19 lockdowns, given the extent to which that strength was down to state support for their borrowers.
Will investors now recognise the lasting change in the sector?
We have seen suggestions of that in recent weeks, alongside more optimism on the macro picture. Between mid October and mid January, bank stocks rose 30%, compared with a 16% rise in the broader Stoxx index.
Meanwhile, bond issuance volumes from European banks have been extraordinarily strong in early 2023.
Spurred partly by a landmark UBS additional tier-1 call, appetite for this issuance has helped mitigate fears about funding among mid-tier lenders in southern Europe.
Spanish lender Banco Sabadell was among banks issuing AT1 debt in the first week of January, for example, attracting €2.4 billion of orders for a €500 million deal priced at 7.375%.
With an average of 400 basis points of capital over minimum requirements, eurozone banks have never been so well-capitalized
There is clearly some basis for a relatively bullish outlook on the banks. They are normally seen by investors as leveraged plays on the economy, but the fact is that they are not as leveraged as they were.
With an average of 400 basis points of capital over minimum requirements, eurozone banks have never been so well-capitalized, according to Morgan Stanley. On average, banks’ loans in Europe now barely exceed their deposits, whereas a decade ago the average loan-to-deposit ratio was well over 150%, according to Citi.
Crucially, banks have also been far more cautious over the past decade in some highly cyclical businesses, notably commercial real estate.
At the same time, there is justification for investor scepticism, too. Although banks emerged from Covid-19 with no serious asset quality blow-ups, a 2020 bank dividend ban in Europe and the UK exacerbated downward pressure on share prices in the short term.
Even if some supervisors regret the ban in private, the political and regulatory environment behind it remains unchanged. Ultimately, if bank profitability proves counter-cyclical, the state will stake a claim – as in last year’s windfall tax in Spain and, to some extent, the blanket mortgage holidays imposed on Polish banks.
By contrast, anything that emphasizes banks’ pro-cyclicality could trigger dividend restrictions, or higher capital requirements, which amount to the same thing. Renewed ECB concern about leveraged finance has led to an increased 2023 pillar-2 requirement at Deutsche Bank, for example.
Banks rushed to issue bonds in early January in part because they expect that the funding environment could quickly get worse.
Although they will see greater impact from higher rates on their margins this year, the big rises in their profitability expectations may already be over, and not just because of inflation.
Mortgage volumes will fall as higher rates hurt affordability, while investment banking revenue can hardly be expected to rise further, given where M&A is.
In the US, net interest margins are set to fall sharply after early 2023, according to Morgan Stanley, pushing up demand for deposits. Europe will soon follow, as the ECB follows the US Federal Reserve’s balance-sheet shrinkage.
Repayment of targeted longer-term refinancing operations (TLTRO) facilities is now accelerating and liquidity coverage ratios have already peaked, according to research from Scope.
Above all, cost of credit will inevitably creep up as the year goes on. But if this crisis is different, it will be because regulation has pushed financial risk away from the banks. Although the extent to which non-bank risk will infect the banks is still uncertain, banks will unquestionably come out of this downturn better than they did in 2008.