European banks have been in the recovery ward for almost a year now. After struggling for much of 2015 and 2016, the Stoxx 600 European bank index rose about 30% in the six months to early 2017. It has barely budged since. Was that rally well-founded?
On the regulatory front, things have moved in a better direction. When the Basel committee belatedly agreed its new rules late last year, the outcome was better than feared for Europe. This is particularly important for French banks, because of their heavy use of internal ratings-based models. More regulatory clarity could now help M&A, which would be the best catalyst for higher valuations.
For banks with important markets businesses, trading revenues looked weaker in the third and fourth quarters of last year than a year earlier, when there was volatility caused by Brexit and the US election. But the volatility in early 2018 around changing US rates expectations is a help, as long it does not get so scary that it derails investment banking deal flow. Alastair Ryan, equity analyst at Bank of America Merrill Lynch, calls this moment “goldilocks in capital markets” for being just right for bank earnings.
The eurozone economy is recovering faster than expected. US rate expectations are edging higher and the dollar interbank market has doubled to 1.9%. However, few are now expecting a late 2018 ECB rate rise, which the most bullish European bank investors imagined a year ago. Euribor is still in the same slightly negative territory of a year ago, at about -0.3%.
Early last year, rates bulls homed in on Commerzbank. The bank itself claimed a 100-basis point rate hike would bring it an extra €1 billion of revenue, boosting its return on equity by two percentage points. Some investors thought things could only get better for Commerzbank.
But Commerzbank’s ROE is still well short of what chief executive Martin Zielke wants; it was even lower than 2017, at just 0.5%. In its annual results statement, the bank admitted its success in growing volumes and customers was still not enough to offset negative rates and lower margins. Clearly, consolidation in Germany has not happened in a meaningful manner, despite the ever-more obvious need.
Commerzbank chief Martin Zielke has enjoyed a rapid share-price rise, despite ROE falling to 0.5%
Investors who bought Commerz shares a year ago would be handsomely rewarded if they sold now. Its share price has risen around 85% in that period. Commerzbank’s 17.9 times price-to-earnings valuation is much higher than any other big European bank. M&A speculation about it might be over-egged. All Commerzbank’s most frequently cited merger partners have downplayed the idea.
Rate increases would have the most immediate impact on southern European banks, because there are fewer fixed-rate mortgages there. Yet domestically focused CaixaBank and Bankia’s net interest margins were lower in the fourth than the first quarter of 2017. Their results showed deleveraging continues in Spain. The recovery in both banks’ shares has stalled.
There has been more progress in Italy. Italian bank stocks have risen by about 40% since early 2017. UniCredit’s cost and asset-quality efforts go on. The deployment of state money in mid 2017 patched up Monte dei Paschi di Siena and the two troubled Veneto lenders.
More worryingly, in countries that were previously mirror images of Italy and safe havens from the sector’s wider woes, the outlook for bank shares has deteriorated – particularly in Sweden, where investors are fretting about a long-delayed end to the housing boom.
In the Netherlands, earlier bullishness around ABN Amro is petering out, caused by new doubts about the lender’s dividends, worries about relations with its state owner and new non-bank competition in mortgage lending.
The UK remains the European banking sector’s biggest bulldog, but one that looks appropriately grumpy. RBS’s return to profit in 2017 was predictable a year ago. The latest anger surrounding its small-business restructuring unit obliterated any chance of triumphalism by chief executive Ross McEwan in early 2018.
Sterling Libor rates (0.6%) are almost twice as high as they were a year ago. The problem is that in the UK, higher rates will do more harm than good to banks because consumer indebtedness is so high. If a big spike in retail defaults has not happened yet, that does not mean it will not come later and harder. After all, the UK has less freedom than the eurozone to ignore rising US rates because of its current account deficit.
UK banks’ profits have suffered in the last five years, despite a relatively rapid economic recovery. Payment protection insurance claims have hurt Lloyds’ profits for longer than anyone expected, including in statutory 2017 numbers. The danger is that the return to higher profits takes so long that it is overtaken by the end of the economic cycle.
This is not unique to the UK. Indeed, banks everywhere must realize that big investments in digital banking – something the UK banks are doing with particular ardour – might never keep up with technological change.
Meanwhile, the eurozone’s current account surplus protects it from neither US nor UK instability, nor digital disrupters, nor its own populists.