Download European banks` balance sheets strongest for a

Investment Insights
Invesco Fixed Income: European banks’
balance sheets strongest for a generation
April 12, 2016
Executive summary
Ian Centis,
Senior Analyst
Invesco Fixed Income
European bank stocks and bonds were punished earlier this year as skeptical investors worried that
European bank balance sheets were not as healthy as previously thought. Questions ranging from
the health of specific European banks to concerns over a weak global macro backdrop to the
potential impact on British banks of the UK referendum on European Union membership raised
doubts about the European financial system. While these concerns have some merit, we believe the
fundamental balance sheet strength of European banks is at a multi-year high. And despite lingering
concerns over the impact of negative interest rate policy (NIRP), so far, we do not see signs of a
major threat to European banks’ profitability as a whole. European bank capitalization, funding
conditions and asset quality have also improved.
Key takeaways
•The profitability of major European banks, as a whole, has been relatively steady over the last few years.
•The picture is more diverse if we look at the evolution of net interest margins (NIM) by country,
against the backdrop of central bank NIRP.
•Since 2007, NIMs have been stable or climbed in Spain, the Benelux countries, Germany, Austria
and Switzerland. They have been more mixed in the UK and France and contracted in Italy.
•We believe the European Central Bank (ECB) will be cautious about pursuing NIRP further, given
the potential adverse effects on Europe’s banks, and will likely seek to protect the banks.
•On the whole, the health of European banks has improved: the capitalization of Europe’s banks has
grown meaningfully; reliance on the bond market for funding has declined and banks are less
susceptible to refinancing risks that could arise if markets close due to risk aversion; asset quality
has improved since the peak of the global financial crisis.
•We believe the most interesting relative value opportunities are in selected solid names in the
junior subordinated additional tier 1 capital (AT1) segment. In particular, we favor Nordic, Swiss
and Benelux banks due to their solid balance sheets and reasonably robust profitability.
Concerns about European banks resurface
European bank stocks declined quite steeply in January and February, and their bond prices were not
far behind. While there has been a recovery, this sudden turn of events left experts searching for an
explanation. Fears were reawakened that there was something seriously wrong with European banks’
balance sheets, but we believe this is not the case and below we explain why.
This document is intended only for Professional Clients and Financial Advisers in Continental Europe, for Professional Clients
in Dubai, Guernsey, Ireland, the Isle of Man, Jersey and the UK; in Hong Kong for Professional Investors, in Japan for
Qualified Institutional Investors; in Switzerland for Qualified Investors; in Taiwan for certain specific Qualified Institutions/
Sophisticated Investors; in Singapore for Institutional/Accredited Investors, and in Australia, and the USA for Institutional
Investors. In Canada, the document is intended only for accredited investors as defined under National Instrument 45-106.
In Chile, Panama or Peru, the document is for one-to-one institutional investors only. It is not intended for and should not be
distributed to, or relied upon, by the public.
Possible causes of market stress
Possible causes of the weakness in European bank assets abound. First, a number of idiosyncratic
events may have undermined investor confidence: the restructuring of four small Italian banks last
year, continued problems at a troubled Portuguese bank and meaningful losses at two major
European banks as a result of regulatory fines, restructuring charges and goodwill write-downs, as
well as weak top lines. Concerns also remain that the weak macro backdrop around the world, which
could lead to further declines in interest rates into negative territory, will impair banks’ earnings
ability. There also is the technical argument that sovereign wealth funds from China and the Middle
East began selling what hitherto had been one of the most resilient sectors, in order to cover losses
in commodities and high yield and to close budget gaps that have opened up as a result of the low oil
price. Finally, the fear that the UK could vote to leave the EU in a referendum has sparked worries
about the future of British banks as well as the overall health of the EU trading block.
While these explanations have some merit, we believe the fundamental balance sheet strength of
European banks is at a multi-year high. While profitability has remained under pressure as a result of
weak economic activity, most banks remain profitable thanks to noticeable declines in loan loss
provisions. There are lingering concerns over the impact of negative interest rate policy, but, so far,
we do not see signs of a major threat to European banks’ profitability as a whole. Indeed European
equities initially reacted positively to the European Central Bank meeting on March 10: the official
deposit rate was cut by a further 10 basis points to -0.4%, but in measures that offset the negative
impact on banks, the central bank also cut its refinancing rate and introduced four additional sizeable
Long-Term Refinancing Operations also costing potentially as little as -0.4%.1
Profitability steady
Figure 1 below shows that total recurring income (excluding the more volatile trading income) among
the major European banks has remained relatively steady over the last few years, despite low market
interest rates over the period. It is, therefore, open to question, whether negative market interest
rates will have a meaningful negative impact on bank revenues. Furthermore, low interest rates have
helped with the maintenance of asset quality, which has contributed to the reduction in loan loss
provisions in 2014 and 2015.
As such, while Q4 results were generally weak across the board, we believe it is too early to deduce an
enduring negative trend from them. We should recall that banks have a tendency to top up provisions
in Q4, and the trading environment in the period was particularly adverse. What’s more, a number of
banks had to deal with one-off items (e.g. restructuring charges, litigation charges, bank levies, and
goodwill write-downs), which are not necessarily indicative of severe underlying weakness.
Figure 1: Aggregate income statement, ex-trading of 25 major European banks
Net interest + dividend income Net fee income Tot recurring income Provisions Costs + provisions Pretax operating income ex trading
% of 2007
average
total
assets
2008
2009
2010
2011
2012
2013
Non-interest costs 2014
2015
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
Source: Fitch Ratings, company accounts, data from Dec. 31, 2007 to Dec. 31, 2015.
European banks: Bankia, Barclays, BBVA, BCP, BNP Paribas, Caixabank, Commerzbank, Credit Agricole, Credit Suisse, Danske
bank, Deutsche, Den norske Bank, HSBC Holdings, ING Group, Intesa, Lloyds Banking Group, Monte dei Paschi, Nordea, RBS,
Santander, SEB, SocGen, Svenska Handelsbanken, UBS, Unicredit.
Net interest margins (NIMs): diverging trends by country
The picture is more diverse if we look at the evolution of NIMs against the backdrop of very low
official rates and, in the last 18 months or so, central banks’ negative interest rates policy (NIRP).
As background, the main source of interest rate vulnerability is from retail mortgages. Consumer
lending tends to be a small proportion of the balance sheet, lending to small to medium-sized
enterprises still fetches reasonable margins, while large corporate lending’s profitability relies largely
on fees and ancillary services. Mortgages, on the other hand, of which a large share are variable rate
or “tracker” mortgages, account for a sizeable portion of loans and are a low margin product that
earns low fees. Spain has the highest share of tracker mortgages, at 98%; Portugal is also in the
90s, while the share in Italy and Ireland is about 60%.2 The negative impact of falling mortgage rates
has to be set against the near-impossibility of lowering interest rates on deposits, especially retail
ones, to below 0%.
Some surprising resilience
Since 2007, NIMs have tended to be stable or climb in Spain, the Benelux countries, Germany,
Austria and Switzerland. The net interest margin’s performance in the latter is surprising, since
Switzerland is one of the European countries that first experimented with very low and negative
rates, and it can be probably ascribed to a buoyant mortgage market coupled with oligopolistic
pricing power. The resilience in Spain is also surprising (and for its international banks), attributable
primarily to operations in the US, UK, Turkey and consumer finance in the case of the two major
banks, which offset weakness in Latin America. The fact that mortgage rates are generally only
re-set once a year is also likely to have an impact in delaying declines in net interest margins,
especially for the more domestic operators.
Mixed performance in UK and France
Developments have differed between different banks in the UK and France. In the UK, the more
domestic institutions have been able to protect and boost their margins over the last four years,
whereas the ones with significant foreign and emerging market operations have witnessed constant
declines over the last eight years as a result of low global rates. In the last year, however, one of the
two institutions with meaningful foreign and emerging market activities has stabilised its margins,
while the other one has suffered from margin shrinkage in China, Hong Kong and South Korea as it
undertakes a deep restructuring of its activities. UK home loans are at a variable rate and this can be
reset by the lender, so it is better able to protect its margins. In France mortgage rates are fixed, but
the borrower is free to re-finance at any time upon payment of a fee. In due course, therefore, it is
conceivable that many borrowers may refinance at lower rates, which initially would earn the bank
good commissions, but, ultimately, would lock it in at low margins.
Long-term weakness in Italy, modest declines for the Nordics
Italy’s largest names have seen progressive NIM contraction since 2008 as a result of the protracted
economic crisis and the rising share of non-paying non-performing loans in the loan books. Finally,
Sweden and Denmark have only seen a very modest easing in NIMs in the last year or two after the
central bank deposit rate fell below zero in July 2014, and, in any case, NIMs remain in line with
historical levels, depending on the bank. In Denmark, asset re-pricing is more difficult, but it has
mitigated the impact of lower rates by passing the cost on to corporate customers.
On balance little evidence so far of negative impact from NIRP
Although central banks’ negative interest rate policy has been in place in the eurozone and Sweden
since the middle of 2014, there is, as yet, very limited evidence outside of Italy of the feared adverse
impact on banks’ net interest income. Moreover, it should be remembered that low rates may have
had other beneficial effects, such as supporting asset quality and therefore depressing provisioning
needs and bringing about capital gains on fixed income and sovereign debt portfolios. There are also
reports that banks have been offsetting lower net interest income by boosting fees and commissions,
but this does not seem to be borne out yet by the available data.
In future some countries will likely be more affected than others…
Of course, further cuts in the deposit rate would presumably cause more damage to NIMs, and this
might be especially the case in Italy and Spain, where loan rates are primarily floating rate at a fixed
spread to euribor over the life of the mortgage. The fact that the rate is typically reset once a year
will slow margin compression, but not avoid it. However, additional rate reductions deeper into
negative territory would again support asset quality and occasion more fixed income capital gains.
But the average impact is likely to be contained
Longer-term, various commentators have highlighted the risks to banks’ profitability. Estimates by
some sell-side houses of the impact on 2017 estimated earnings from a further 10 basis point cut in
interest rates average about a 2-3% earnings per share decline, with declines of up to 10% for more
exposed banks, before considering the offsetting effects of the newly-instituted ECB funding
programs.3 This leads to an average impact on Return on Tangible Equity of 40 basis points. This
sounds manageable from a credit standpoint. Equity valuations would likely be more sensitive, as
demonstrated by on-going weakness since December 2015 and despite a brief rally in early March
partly in response to the new measures cheapening the cost of funding from the ECB.
Possible perverse effects of NIRP abound
NIRP risks a number of perverse effects:
•A slowdown in lending in Europe as it would cease to be profitable,
•Falls in cross-border lending in Europe that would hinder the development of the single market,
•Higher rates on new lending to offset weakening margins on loans already granted at older terms,
•Higher lending to riskier credits and efforts to shrink the deposit base to avoid having to place such
funds at a loss,
•A slowdown in wealth management fees as yields on savings products fall too low to justify them.
This list does not even take into consideration the likely deleterious effects on other sectors, such as
insurance. All these effects are basically the opposite of what the ECB is aiming to achieve.
Additionally, there seems to be fairly little evidence that negative interest rate policy is having any
effect in weakening the currency or combating deflation, and only appears to be transmitted to longer
maturity and higher risk assets. As such, it seems unlikely that the central bank will continue to drive
rates ever lower, and, as we have seen, it would, in any case, likely seek to protect the banks.
The ECB is aware, but for the moment downplays the profit & loss effect
Indeed, it seems the ECB was not deaf to banks’ concerns. In a speech on March 2, ECB board
member Benoît Cœuré assured listeners that the ECB is well aware of the risks of narrowing NIMs,
and developments are monitored on a regular basis. On March 10, the ECB went ahead with a
10 basis point deposit rate cut to -0.4%, which banks feared but also expected, but also surprised
the market by cutting the refinancing rate by 5 basis points to 0% and instituting four additional
Long Term Refinancing Operations for banks that could cost as little as -0.4% as well, depending on
usage, thereby largely negating the adverse effect of the deposit rate cut. Additionally, the bondbuying program was increased by EUR20 billion per month to EUR80 billion and broadened to
include non-bank corporate debt, which should also help banks.
In his March 2 speech, Mr Cœuré also went on to say that, according to the central bank's
observations, aggregate net interest income in 2015 increased as banks grew volumes and reduced
interest expense. Moreover, benefits from lower provisions and higher capital gains were also
recorded. He went on to remind the audience that the adverse impact on banks’ balance sheets of a
less accommodative monetary stance would also risk being severe in terms of asset quality. Going
forward, as solutions to the low rate environment, he suggested a greater emphasis on fee income
and cost control, possibly aided by more bank sector consolidation.
Muted impact on profitability so far, measures likely to shield banks in future
To conclude, the impact of lower rates on profitability has so far been muted. Going forward, the
impact may increase, but to a lesser degree than feared, given the measures also taken to support
funding from the ECB. Judging from sell-side estimates, negative rates looked more of a problem
from the standpoint of equity investors than credit investors, even before taking into account the
positive effect of lower official borrowing rates. Southern European banks were seen as more likely to
be adversely affected before the effect of the new ECB funding programs is considered. The probable
perverse effects of negative interest rates are likely to put a floor to the extent of central banks’
actions, as the ECB’s March shift away from further interest rate cuts and toward measures to
provide cheap official funding to the banking sector seem to show.
European bank capitalization
By all standard measures, the capitalization of Europe’s banks has grown tangibly, as shown in Figure 2
below. Measures of core capitalization have risen due to the addition of new capital and the decline
in risk-weighted assets (the denominator), which in some cases has also resulted from the diminution
of the risk weighting applied to those assets. However, even the purer equity/assets measure, which
is unaffected by the window-dressing effect of lower risk-weights, has risen by 88% since 2008, as
seen in the chart below. Both the governor of the Bank of England and the head of supervision at
the ECB recently commented that capitalization is close to the desired levels. Moreover, all national
bank supervisors now run regular and reasonably stringent stress tests, and the results show that
most institutions would still maintain adequate capitalization.
Figure 2: Amalgamated capitalization of 25 major European banks
• Equity/assets • CET1 ratio (RHS) • T1 ratio (RHS)
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
%
%
7
16
14
6
12
5
88%
10
4
8
3
2
6
4
Source: CreditSights, company accounts, data from Dec. 31, 2007 to Dec. 31, 2015.
European Banks: Bankia, Barclays, BBVA, BCP, BNP Paribas, Caixabank, Commerzbank, Credit Agricole, Credit Suisse, Danske
bank, Deutsche, Den norske Bank, HSBC Holdings, ING Group, Intesa, Lloyds Banking Group, Monte dei Paschi, Nordea, RBS,
Santander, SEB, SocGen, Svenska Handelsbanken, UBS, Unicredit.
2015 calculated as an average of Fitch Ratings ratios, 14 reporting banks only.
European bank funding
A combination of these 25 major European banks shows how the loan/deposit ratio has declined
from over 120% in 2008 to just 100% now, as seen in Figure 3 below. Reliance on the bond market
for funding has therefore declined, and banks are less susceptible to the refinancing risks that arise
in the event the funding market closes as a result of risk aversion. Of course, banks will still need to
roll over their maturities. Also, with the onset of Total Loss-Absorbing Capacity (TLAC) and Minimum
Required Eligible Liabilities (MREL) rules intended to ensure that in future it will be mainly investors
rather than tax-payers that finance exceptional losses, banks will need to issue compliant senior debt.
However, they have been given four years to meet their targets.
Figure 3: Amalgamated loan/deposit ratio of 25 Major European banks
• Loans/deposits
2007
2008
2009
2010
2011
2012
2013
2014
2Q15
2015
%
140
120
100
80
Source: CreditSights, company accounts, data from Dec. 31, 2007 to Dec. 31, 2015.
European Banks: Bankia, Barclays, BBVA, BCP, BNP Paribas, Caixabank, Commerzbank, Credit Agricole, Credit Suisse, Danske
bank, Deutsche, Den norske Bank, HSBC Holdings, ING Group, Intesa, Lloyds Banking Group, Monte dei Paschi, Nordea, RBS,
Santander, SEB, SocGen, Svenska Handelsbanken, UBS, Unicredit.
2015 calculated as an average of Fitch Ratings ratios, 14 reporting banks only.
It is also worth noting that over the last few weeks the level of short-term money market funds
invested in the euro market, about 50% of which comprises bank securities, has remained
reasonably constant, as seen in Figure 4. The money market generally responds quickly and often
ahead of the long-term bond market in times of stress with withdrawals. As such, it is a positive sign
that the amount of bank funding provided by the money markets has remained constant.
Figure 4: Euro money market funds net asset value
EUR
bn
12/25/15
1/1/16
1/8/16
1/15/16
75
72
69
66
Source: IMMFA, data from Dec. 25, 2015 to Feb. 12, 2016.
1/22/16
1/29/16
2/5/16
2/12/16
European bank asset quality
The major banks’ asset quality has also shown improvement since the peak of the crisis. From a high
of 6.5% of total loans in 2013, impaired loans declined to 5.5% as of the end of the second quarter
of 2015 (the latest available report for CreditSight's European Megabank), as seen in Figure 5.
At the same time, reserve coverage of impaired loans has improved to 55% (Figure 5). The bulk of
impaired loans are in Italian banks (where impared loans are in excess of 17% depending on the
bank) due to the slow legal process of foreclosure and disposal. However, even in their case, the
volume of impaired loans has all but stopped rising, and coverage seems generally adequate.
Most other major European countries' banks show impaired loan ratios of well below 6%.4
Figure 5: Asset quality of 25 major European banks
• Gross impaired loans/Total loans • Reserves/Impaired loans (RHS)
2007
2008
2009
2010
2011
2012
2013
2014
2Q15
%
7
80
6
70
5
60
4
50
3
40
2
30
Source: CreditSights, company accounts, data from Dec. 31, 2007 to June 30, 2015.
European Banks: Bankia, Barclays, BBVA, BCP, BNP Paribas, Caixabank, Commerzbank, Credit Agricole, Credit Suisse, Danske
bank, Deutsche, Den norske Bank, HSBC Holdings, ING Group, Intesa, Lloyds Banking Group, Monte dei Paschi, Nordea, RBS,
Santander, SEB, SocGen, Svenska Handelsbanken, UBS, Unicredit.
Relative value
We believe the most interesting relative value opportunities are in selected solid European banks in
the junior subordinated additional tier 1 capital (AT1) segment. In particular, Nordic, Swiss and
Benelux banks display solid balance sheets and reasonably robust profitability. As such, buffers to
AT1 coupon suspension triggers are ample, in our view. They have shown much greater resilience
than the rest of the complex. Other European banks do not display such solid fundamentals or
buffers to coupon suspension triggers, making these securities somewhat riskier, in our view,
although yields are generally higher, as seen in Figure 6.
Figure 6: Yield ranges for AT1 securities by country of issuer
• Yields to call • Yields to perpetuity
%
Nordic
banks
Swiss banks
(5.125%
trigger)
Benelux
banks
UK
banks
French
banks
German
private
banks
Italian
banks
Spanish
banks
20
16
12
8
4
Source: Bloomberg data as of March 8, 2016.
The other attraction of investing in these countries’ AT1 securities is that we believe supply will be
predictable. In the case of the Swedish and Benelux banks, this is because they have issued either all,
or close to, the amount admissible for regulatory purposes, while the Swiss banks will, in future, be
required to issue securities with more stringent write-down or conversion triggers, so that the
existing lower-trigger ones will likely acquire scarcity value.
Supply calculations are not as clear with respect to senior bonds and Tier 2 (T2) subordinated bonds.
Both types can and will be used to meet global TLAC and/or European MREL targets for additional
loss-absorbing liabilities, and that could mean significant issuance depending on the bank.
Furthermore, as newly-issued senior debt will be eligible to absorb losses, which was not the case
previously, spreads are likely to widen to reflect this risk, depending also on the size of T2, AT1 and
equity cushions beneath this class in the capital stack.
The relative value of senior and T2 securities versus AT1s is also unconvincing in most cases, in our
view. For example, where Swedish AT1 spreads are around 600-700 basis points, T2 spreads are in
the low 200s area and senior spreads at about 100 basis points or less.5 Other banks in Europe
display similar, if not identical, multiples between the different categories of liabilities. For instance, in
the case of Italian banks, the AT1/T2 multiple is closer to 2X than 3X.5 In the case of Italian banks,
the market sees AT1 and T2 risks as being more closely aligned than in the case of Swedish banks,
and we certainly agree with that. We therefore invest in the lower part of the capital structure of the
more solid Swedish banks, but choose to remain prudently in the in the upper strata of the capital
stack when it comes to riskier European banks.
1 Source: ECB, March 10, 2016.
2 Source: Morgan Stanley, “Negative rates a “dangerous experiment” with diminishing positive impact?” Feb. 17, 2016.
3 Source: Goldman Sachs, “European Banks: A 10 basis point ECB rate cut is manageable (and priced in), but further cuts
become less so,” March 7, 2016.
4 Source: Invesco, based on bank annual reports, as of Dec. 31, 2015.
5 Source: Bloomberg L.P., March 11, 2016.
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accordance with the conditions specified in Section 305 of the SFA, or (iii) otherwise pursuant to, and in accordance with the conditions of, any other applicable
provision of the SFA. This document is for the sole use of the recipient on an institutional offer basis and/ or accredited investors and cannot be distributed within
Singapore by way of a public offer, public advertisement or in any other means of public marketing.
Issued in Singapore by Invesco Asset Management Singapore Ltd, 9 Raffles Place, #18-01 Republic Plaza, Singapore 048619.
Taiwan
This material is distributed to you as a Qualified Institutions/Sophisticated Investors. It is not intended for and should not be distributed to, or relied upon, by the
members of public or the retail investors.
Issued in Taiwan by Invesco Taiwan Limited, 22F, No.1, Songzhi Road, Taipei 11047, Taiwan, (0800-045-066) which holds a Taiwan Financial Supervisory
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United States
Issued in the United States of America by Invesco Advisers, Inc., Two Peachtree Pointe, 1555 Peachtree Street, N.E., Suite 1800, Atlanta, GA 30309.
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