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For professional investors only European banks: Are we back to 2008? February 2016 David Moss Head of European Equities The performance of the banking sector, and in fact the whole financial sector, since the start of 2016 would suggest that if we are not quite back to 2008, then at the very least risk is on the rise again. But is this really the case? Institutional business: Chart 1: European banking stocks performance year-to-date 0207 011 4444 [email protected] bmogam.com 140 21/02/16 17/02/16 13/02/16 09/02/16 05/02/16 01/02/16 28/01/16 120 24/01/16 130 20/01/16 bmogam.com/adviser Discretionary sales: 150 16/01/16 [email protected] 160 12/01/16 0800 085 0383 170 08/01/16 Adviser sales: 180 04/01/16 institutional.enquiries@ bmogam.com 190 31/12/16 +44 (0)20 7011 4444 STOXX Europe 600 Banks Price (EUR) Contact us We believe not. The banking sector in Europe is fundamentally better positioned than in the dark days of the “Global Financial Crisis”. European banks have raised over €800 billion of new capital since 2007 1 and this doesn’t include retained earnings (yes, the majority of banks have made profits!). Source: Bloomberg, as at 22 February 2016 This has been driven in part by the banks’ own desire to be more secure but primarily by the regulators, determined to make the inter-connected global financial system safer. They want to make sure that never again are they called to account for the near failure of many major banks. To this end, in addition to new equity, they have restricted dividends to shareholders, hugely increased risk weightings (the amount of capital banks have to hold against each loan), introduced new hybrid capital (the now infamous ‘CoCo’s’ or AT12) and forced the introduction of ‘bail-in’, a process by which debt-holders share in bank failures, as evidenced in Portugal with Novo Banco. Strengthened balance sheets As well as the above-mentioned initiatives, banks have cleaned up the assets on their balance sheets and no longer own the multitude of leveraged, mis-understood alphabet soup of pre-crisis products, e.g. CDO’s, CDO squared, CLO, synthetic CLO’s, RMBS, and so on3. Last of all, the real problem for the banking sector in 2007-9 was not capital or the amount of bad assets on the balance sheet, it was liquidity and the Goldman Sachs - Equity Research note “Europe: Banks”, 9 February 2016. 2 ‘CoCo’s’: Contingent convertible capital instruments, AT1: Additional Tier 1. 3 CDO: Collateralized Debt Obligation, CLO: Collateralized Loan Obligation, RMBS: Residential Mortgage-Backed Security. 1 Continued PAGE 2 inability to fund themselves as depositors became nervous (remember the queues outside Northern Rock?) and funding markets closed. Lacking capital and liquidity, banks became forced sellers of assets at the worst time. Bear in mind that the National Asset Management Agency (NAMA), the Irish body that took all the really bad loans off the balance sheets of the Irish banks, looks set to report a substantial profit once its role is finally finished. Today this is no longer an issue, tightened regulation means that banks cannot fund themselves with short-term funding alone as new regulations mean that banks must have a higher amount of long-term funding and substantial liquidity in case of market stress. 4 240 220 200 180 160 140 03/12/11 03/11/11 03/10/11 03/09/11 120 100 03/08/11 6. The rise of the AT1. AT1 is an alternate type of capital, a bond that converts to equity in the event of a bank’s capital ratios falling below certain levels. These were created by regulators, are new and untested in stressed market conditions but were readily bought by investors hungry for Chart 2: European banking stocks performance in 2011 03/07/11 5. Uncertainties on Italian NPL’s (non-performing loans) and the slow creation of the Italian bad bank has hurt sentiment and again raised fears on the quality of banks’ assets despite the ECB’s own asset quality review in 2014 addressing this. We have been here before. Here is the performance of the banking sector in 2011: 03/06/11 4. The bail-in of debt holders of the Portuguese bank Novo Banco made the bond market aware that this threat is real in poorly capitalised, badly run banks. One more thing…. 03/05/11 3. Regulation - despite comments from Carney and Draghi to the contrary, there remain fears of ever-higher capital needs depressing returns. The one area where banks have surprised positively in this reporting season though is in the payment of dividends. This would be unlikely, we would suggest, if regulators were still concerned about capital levels. 03/04/11 2. There is a fear of slowing global growth, whether in the US, China or Europe. 03/03/11 1. L ow interest rates - the banks have an earnings issue. Low interest rates are bad news for banks who make money from lending out the money we all keep in current and short-term deposit accounts. Ever lower rates have been a consistent driver of downgrades in the sector’s profits. We do not advocate, however, indiscriminate buying of the sector. At BMO Global Asset Management, our investment process leads us to buy good quality businesses with durable competitive advantages, and we do believe that such businesses exist in the financial sector. The wholesale selling of the sector gives us the chance to buy these higher quality businesses at better prices giving us a bigger margin of safety. Examples of such companies include well run retail and commercial banks such as ING, Handelsbanken and DNB, as well as asset gatherers such as Azimut in Italy or the world’s largest private bank, UBS. 31/01/11 Well, it’s clear that there are a number of issues which at the very least have dampened sentiment, which in itself can have a significant impact on an economically sensitive sector such as the banks. The issues being: So, there are lots of issues and the confluence of them has significantly hurt sentiment. However, we believe that these issues are manageable in an environment where banks have strong capital ratios, regulators are on the ball and central banks are willing and able to provide adequate liquidity. Despite the underlying positives in fundamentals, adverse sentiment has pushed valuations down, in some cases to lows not seen since the financial crisis. 31/12/10 So what has been the cause of the sector’s recent very poor performance? 7. Oil & Gas - banks are big lenders to the oil & gas sector and this again has raised fears about increased losses. These types of fears will clearly arise in times of overt market downturns but so far the banks have provided detailed disclosure of their exposures and have, in the main, stress tested portfolios for the current low oil prices with the result that losses do increase but not to unmanageable levels. STOXX Europe 600 Banks Price (EUR) A final point to consider: central banks weren’t ready last time. There were no co-ordinated European Central Bank (ECB) liquidity facilities - no LTRO, TLTRO etc4. Central banks now are very clear on where they stand: ready to provide whatever liquidity the sector needs. the extra yield they offered. As the recent, partly technical, issue of whether Deutsche Bank could pay the coupon caused concern it became clear that this was a market with close to zero liquidity in times of stress with knock-on impacts on conventional bonds, credit default swap (CDS) spreads and equities. Source: Bloomberg, as at 22 February 2016 LTRO: Longer-Term Refinancing Operations, TLTRO: Targeted Longer-Term Refinancing Operations. Continued PAGE 3 The issues were different but the sector also had significantly less capital. Here is what happened in the following 18 months: 190 180 170 160 150 140 130 120 02/06/13 02/05/13 02/04/13 02/03/13 02/02/13 02/01/13 02/12/12 02/11/12 02/10/12 02/09/12 02/08/12 02/07/12 02/06/12 02/05/12 02/04/12 02/03/12 02/02/12 110 100 02/01/12 STOXX Europe 600 Banks Price (EUR) Chart 3: European banking stocks performance Jan 2012 to Jun 2013 Source: Bloomberg, as at 22 February 2016 Will history repeat? Probably not. Mario Draghi cannot stand up again and say “we will do whatever it takes” and interest rates are already low (see point 1 above) but it might rhyme. Views and opinions expressed by individual authors do not necessarily represent those of BMO Global Asset Management. © 2016 BMO Global Asset Management. All rights reserved. BMO Global Asset Management is a trading name of F&C Management Limited, which is authorised and regulated by the Financial Conduct Authority. CM08175 (02/16). AT, BE, DK, FI, FR, DE, IE, IT, LU, NL, NO, PT, ES, SE, CH, GB.