27 Apr 2020 / Insights & Analysis
Opportunity of a lifetime?
Matthew D. Hansen
Head of Research
27 Apr 2020 / Insights & Analysis
Head of Research
33 years is a long time…A picture as the saying goes is worth a thousand words and Chart 1 is no exception. The STOXX Europe 600 Banks Index, the most commonly used benchmark for European banks valuations, closed at a dismally low level of 82 on 24 April 2020. To put this in perspective, the index has not reached this level even during the depths the global financial crisis (GFC) of 2008. In fact in the last time it has seen this level was in the fall of 1987, following the sharp sell-off in the global stock markets which began in the US. The fact that the index is back at 1987 levels is truly astonishing considering that the size of the European economy has more than doubled in the meantime (see Chart 2), and the size of the bank’s balance sheets have grown at an even faster pace.
But it wasn’t always like this. As Chart 3 illustrates, the European and US banks valuations used be comparable, until the GFC. While the benchmark indices for both began 1992 around the level of 100, and both reached levels of well over 500 prior to the onset of the GFC, the Dow Jones US total market banks index has in fact recovered post the GFC to reach those levels again prior to the recent sell-off. The same cannot be said of the STOXX 600 Europe, which has struggled since the GFC, seldom even reaching the level of 200. On 24 April 2020 the US banks index closed at 313, compared to its European counterpart closing at a level of 82.
Furthermore, similar trends can be observed when looking at valuation metric such as the Price to Book Value, with the European banks consistently underperforming their US counterparts after the GFC.
2010s - the lost decade for European banks?It may be somewhat unfair to describe the 2010-2020 as the lost decade for European banks, as doing so ignores the progress that has been achieved during the decade. Objectively, European banks capital ratios and the gross amount of primary loss absorbing capital are multiples of what they were prior to the GFC. The asset quality has also substantially improved and in some cases exceeded levels seen prior to the GFC, with other fundamental metrics also reporting improving trends. But profitability has suffered even before the onset of the COVID-19 crisis. As a result, the biggest beneficiaries of the last ten years have in fact been bank credit investors – the holders of AT1, Tier 2, senior debt and covered bonds and this to some extent came at the expense of equity investors. Why? Simply put, higher capital means lower return on equity (ROE) everything else held equal.
So what could have been different? As the readers will appreciate Europe is not one country and there are in fact major differences between banking systems of various European countries. For example the French and the UK banking markets are fairly oligopolistic, with top 5 institutions dominating the market. On the opposite side of the spectrum, the German banking system is very fragmented, which results in considerable pressure on profitability. Hence we focus here on those themes that have broader impact on the European bank universe and where relevant compare them to the trends in the US.
Zero to negative benchmark interest rates. This is perhaps the favorite excuse used by the European banks to justify their underperformance as compared to the US counterparts. And as per Chart 5, it is hard to argue with the fact that rates in Europe have been consistently below those in the US after the GFC. That being said, banks management teams’ expectation of normalization of rates environment has been always somewhat naïve, even if we are of course judging from the position of hindsight. Low rates environment generally translates into limited revenue growth, but rather than complaining about low rates (something the banks can do little about), European banks should have been much more aggressive in managing operating costs. Furthermore it is not just rates but also differences in product mix as US banks had a much higher level of net interest margin (NIM) even prior to the GFC.
Difference in product mix. In general European banks have more lower margin assets on their balance sheets as compared to their US counterparts (please see Chart 6). Perhaps the best example of this is mortgages, which comprise a very limited portion of US banks’ balance sheets due to originate and distribute model, sponsored by the GSEs (e.g. Fannie Mae and Freddie Mac). But in Europe, mortgages comprise a significant portion of the loans books. They are generally considered to be safe assets from credit point of view and have a low risk weight, but this also translates into a much lower lending margin compared to unsecured lending. Furthermore, prior to the GFC, banks were operating with much lower capital ratios and much higher leverage, which is how European banks were able to report ROEs comparable to that of their US counterparts. However post GFC this became impossible as banks had to raise and maintain significantly higher capital ratios.
European banks have been much slower in cleaning up their balance sheets after GFC compared to their US counterparts. This was a theme perhaps most relevant to southern European banks though not necessarily so (let’s not forget that Germany had their share of ‘bad banks’). But how did this happen? The bottom line is that there were too many undercapitalized banks that would have needed to take significant asset write-downs in order to value impaired assets at levels where they could be sold to a third party, and hence clean their balance sheet so they could make new loan commitments. Their weak provisioning and capital levels meant they simply couldn’t take the write-downs and stay solvent. But this in theory shouldn’t matter as weak banks – particularly those that are not systemically important should be allowed to fail, right? In theory yes, but in practice this wasn’t the approach that the ECB and the national authorities took after the GFC. And as the ECB extended the type of securities it would accept as collateral (e.g. so called retained covered bonds are prime example of this), even the weaker banks were able to access liquidity and as a result were not necessarily distressed sellers. Banks generally won’t go under because of lack of capital per se – rather the problem is if this capital deficit leads to liquidity crunch. But as the actions of the ECB along with national central banks took the threat of liquidity crunch off the table, they also blunted the sense of urgency to fix the problems. While that may have alleviated short term pain, in has no doubt contributed to the lackluster economic growth that we have seen in the EU throughout the 2010s.
Management failure – investment banking. It is often forgotten that the GFC has taken place at the same time as the Basel Committee for Banking Supervision (BCBS) started implementing new regulation known as Basel II, which later evolved into Basel III (and more recently Basel IV). While the details of all the regulatory changes are beyond the scope of this publication, the key point is that these made some of the formerly most profitable areas such as securitization much less profitable or uneconomical altogether, due to significant increase in capital requirements. But these major changes were often treated by managements as being cyclical rather than secular in nature. Furthermore having scale has become much more important to maintain profitability, a trend that has also hurt European banks’ investment banking operations.
Management failure – commercial and retail banking.European banks in general have been perennial underperformers in cost management. We stress here that there are exceptions – such as Scandinavian or Dutch banks that have managed to cut their retail branch footprint by over 60-70% in the last ten years but these are outnumbered by those that have been complacent. Bottom line is that if one looks at the cost income ratio of US banks it is on average 10% below that of European banks.
Lack of consolidation – It is safe to say that the need for more consolidation is something most regulators and policymakers in Europe agree on in principle, although perhaps less so in practice. The aborted merger of Commerzbank and Deutsche Bank in the spring of 2019 is just one example. The challenge is that there are still far too many regulatory as well as other legal hurdles for consolidation to take off at scale. But this will perhaps change as a result of the challenges brought on by the COVID-19 crisis.
Growth story, yield story or no story – The latest turn for the worse in European banks equity valuation came in no small part due to regulator’s advice to suspend dividend payments for the duration of the COVID-19 crisis. This ‘stick’ of dividend suspensions was accompanied by the ‘carrot’ of temporary loosening of countercyclical capital buffers and provisioning rules in order to encourage banks to continue to lend. Unfortunately, most large European banks have built their entire investment thesis on high dividend payout ratios and attractive dividend yield. Needless to say the dividend suspension has invalidated this thesis almost overnight. In order for companies to maintain a healthy share price, they need to have a growth story or a dividend story. Alas for most large European banks presenting a growth story with lackluster macro-economic environment even prior to COVID-19 crisis was a non starter, and now the dividend yield story thesis has also been invalidated.
European banks – the past and the futureIn the book Sleepwalkers: How Europe went to War in 1914, author Christopher Clark retells the story of the outbreak of the First World War and its causes. He also spells out in fascinating level of detail the personalities and the decisions that led the world to war, and in the process debunks the rather popular view that it was inevitable. Similarly there is nothing inevitable about where European banks find themselves today, or the lost decade – it happened as a result of decisions taken by individuals. That’s the bad news perhaps but there is also good news which is that most of the causes of underperformance are fixable – given the right mix of expertise, people, capital and technology. It is also worth noting here that successful investors in the European banks space need to take view during this period of uncertainty as once it direction of travel is clear 90% of the value will likely have been priced in.
“Be greedy when others are fearful and fearful when others are greedy.”
Europe vs US performance – InsuranceIn closing we also note that the ‘European discount’ is present in other financial services sectors such as insurance, although it is nowhere near as large as it is for banks. Alas there simply isn’t enough historical data and comparable companies on both side of the Atlantic to look at similar data for asset managers or payments space.
Head of Research