FSC Market Opportunities: European Banks

Despite a strong rally since the beginning of 2021, European bank share valuations remain close to multi-decade lows by most metrics. This offers an attractive entry point for transformational investors. The most appealing operations are those with viable business models grounded in the real economy, such as established old-style regional banks in need of transformation, or undermanaged local branches of foreign flag carrier banks.

The European banking sector represents total assets of more than €45 trillion or approximately three times total EU GDP, making it Europe’s largest industry by far in asset terms. Country banking markets differ quite substantially from each other as each developed at its own speed and in the context of their home economies. So, while the UK and France dominate the ranking by assets, they are a distant 5th and 6th in terms of credit institutions. Germany, however, has a highly fragmented banking system with many savings banks, cooperative banks and privately owned institutions.

Many describe 2010-2020 as the ‘lost decade’ for European banks, ignoring the progress achieved after the 2008 financial crisis. Objectively, European banks’ capital ratios and the gross amount of primary loss-absorbing capital are multiples of pre-2008 levels. Asset quality has also substantially improved. Nonetheless, profitability was suffering even before the COVID-19 crisis and most business models have not been fundamentally repositioned since 2008 for an improved Return on Equity (RoE) trajectory.

According to the November 2020 ECB Financial Stability Report, H1 2020 saw a marked decline in euro area banks’ RoE, from over 5% in Q4 2019 to just above 2% in Q2 2020. This change was driven predominantly by higher loan loss provisions and banks’ impaired income-generation capacity as a result of the economic fallout from the pandemic. Cost reductions have only partially offset this.

In an environment characterized by low interest rates, an expected increase in credit losses, tightening credit standards and the phasing-out of state guarantees, euro area banks may find it harder to generate income by compensating for lower margins with higher lending volumes. At the same time, euro area banks have continued to make loan loss provisions as they are increasingly confronted with missed payments and corporate defaults. However, provisioning remains below levels observed during previous crises and those in other jurisdictions, notably the United States.

The sector’s challenges are clear, but opportunities lie within. Topping the list is the overdue need for aggressive adjustment of business models to reflect ultra-low interest rates, focusing chiefly on product mix and operating costs. Exiting non-profitable and marginal client relationships, while eliminating low margin products, allows resources to be shifted to asset classes with higher returns, with a significant impact on overall RoE. As for expenses, banks are still lagging in modernizing their technology and minimizing their branch footprints.

European banks have been slow in cleaning up their balance sheets since 2008. While the ‘extend and pretend’ approach may have alleviated short term pain, it has no doubt contributed to the lacklustre economic growth that we have seen in the EU throughout the 2010s. Looking at underperforming divisions, the widespread current practice of cross-selling to push a client relationship into profitability needs to be replaced by products which are all profitable in their own right.

Larger lenders are trimming their geographical footprints, leaving unwanted yet solid foreign subsidiaries up for grabs. This trend is potentially set to accelerate as banks attempt to fix diseconomies of scale in their businesses and address the need to raise capital. Furthermore, regulators have pushed to simplify corporate structures. The incentive here has been the minimum supervisory capital ratio, which can be lowered if an institution can prove a more straightforward business model. Excess capital may then be returned to shareholders.

Many European banks are stuck in varying states of ‘limbo’. A recent report by Oliver Wyman shows that nearly 25% of the industry’s capital will sit in institutions with Common Equity Tier 1 (CET1) ratios below 12% and returns below 8%. They face immediate challenges driven by weakened balance sheets and an inability to rebuild organically. A fifth of these banks face the prospect of returns below 4%. Many will need a round of restructuring, will remain vulnerable to further capital hits, remain risk averse in lending, and will struggle to fund transformation efforts. One in 10 of Europe’s banks will be in a ‘deep limbo’, adequately capitalized but generating returns of less than 4% in 2022.

Significant opportunities exist in essentially viable institutions that can become more profitable via consolidation and thorough restructuring. The prime targets include non-core foreign subsidiaries of larger European banks, established old-style regional banks and under-developed specialty lenders that will benefit from modernised processes and distribution.