Confidence is breaking out in the most unexpected quarters, as the ECB’s quantitative easing programme gets underway, notably among analysts covering European banks. While bank stocks have tracked the broad market indices pretty closely for the past 12 months, Société Générale now recommends going long bank stocks versus the index in expectation that, even after a 15% rise so far this year, the bull run in European equities still has a way to go and that banks will be prime beneficiaries of renewed growth in Europe.
Deutsche Bank analyst Jan Schildbach argues that banks finally turned a corner in 2014. Core revenues are getting better, loan losses are falling substantially and capital ratios have climbed to sustainable levels. Deleveraging looks to be coming to an end, with loan growth resuming while loan loss provisions fell by a third last year: back to pre-crisis levels. This, together with lower one-off hits from litigation and goodwill write-offs, helped post-tax profit to more than double to €43 billion for the 20 largest eurozone banks last year.
These banks managed to grow their balance sheets by 8% in 2014 while still improving capital. Average Basle III common equity tier-1 ratios now stand at 11.5%, with only a couple of banks still below 10%. Schildbach’s colleagues at Deutsche have begun screening banks for their capacity to return excess capital through dividends and share repurchases, identifying strong total distribution capability at banks such as ING, KBC, Lloyds, Danske and HSBC among others.
Call us churlish, but Euromoney struggles to share this optimism.
Bank earnings may well be picking up from a low base and balance sheets expanding again after alarming contraction, but this on its own does not make banks good businesses for asset managers to invest their clients’ money in. The existential challenge of producing a sustainable return on equity above the cost of equity required to compensate investors for the risks and volatility in bank earnings remains unresolved, as it has for five years now and counting.
In February, Citigroup analysts raised the return on equity forecasts for European banks in their global coverage universe to an underwhelming 7% for 2015. That’s a marginal improvement on the recent low of 6% in 2009, but still well below the 15% that prevailed in the mid-2000s. Citi analysts expect only 10% for US banks, up from 8% at the low in 2009.
Reduced leverage has been the main driver of these constrained returns. Regulators imposing higher capital and leverage ratios have hoped that by making banks safer they will encourage investors to accept lower utility-like returns for funding them. But big doubts remain over this. Banks are not utilities. They are a scorpions’ nest of risks.
In attempting to trace how Europe’s old banking system will cope with its new capital requirements, Alberto Gallo, macro credit analyst at RBS, pointed out last month that across the developed markets bank capital measured by book value of equity against total assets is only just picking up from a 200-year low. Banks may have optimized their regulatory risk weights but balance sheets remain very large, including as a percentage of GDP in many European countries. And while European banks are now operating on leverage ratios of 3%-4%, if regulators want a truly resilient banking system they should probably impose ratios of closer to 6%, Gallo argues.
If investors are to categorize banks as investable, surely that requires greater certainty that new litigation costs are not building up to replace those that banks have slowly worked off from a slew of misdeeds including mortgage underwriting, Libor and other market manipulation, sanctions busting and mis-selling.
As well as personal greed, what drove much of this was the institutional inability of banks to make acceptable returns from day-to-day banking. So let’s look again at those revived earnings. In Europe, the question arises: how much stems from capital gain on sovereign bonds held at the insistence of regulators on which yields have plummeted due to central bank intervention? Gallo looks at Spanish banks. In 2014, the five largest Spanish banks made €10.4 billion of net profit between them. But RBS estimates that around €4 billion of this was carry from their €181.6 billion of Spanish government bond holdings, using EBA stress test data on sovereign holdings at the end of 2013.
Those profits are unlikely to be repeated. They could even reverse and turn into losses. And whatever happens with sovereign bonds, prevailing benign credit conditions cannot disguise that default risks and high capital costs of SME lending make that a business offering very low returns. Investment banking seems to produce acceptable returns maybe one year in five. And some big banks are even losing faith in their own return on equity promises. In February, HSBC cut its medium-term return on equity target from 12%-15%, down to above 10%.
Bank stocks at low price-to-book value might make a decent short-term bet for day traders. But the biggest spikes recently have come from underperformers such as Standard Chartered and Credit Suisse appointing new chief executives. That’s a nice little earner for some, but hardly any basis for long-term allocation of investment capital, absent fundamental business model restructuring.