Sense of balance
The parlous state of the European banking system means it is going to be a huge task to find the right balance between restoring confidence and building profits
“There is a light that never goes out,” the greatest pop band ever back in the 1980s used to sing. At the time, The Smiths were talking about the desperate hope that a long night would finally end in the arms of the loved one. Today, however, the light that never goes out is red and it is blinking, and the message is a much more pedestrian one. Instead of the hope of romance, it gives us a warning that there still is something wrong with the European banking system. And if a 10-ton truck crashes into us, it will likely be filled with toxic assets, and it is going to be neither a pleasure nor a privilege for anyone involved.
Comparing to another popular art form, if the suspicions about the health of Europe’s banking sector could be turned into a Hollywood character, it could very well be Michael Corleone on The Godfather III. “Just when I thought I was out, they pulled me back in,” wailed Al Pacino memorably, although not in one of the best performances of his great career.
In Europe, banking fears have been dragged in and out of the picture in a similar way that youngest Corleone found itself embroiled in the nasty deals of his Mob family.
Last summer, after Mario Draghi, the president of the European Central Bank, made a blunt promise that no efforts would be spared to keep the euro safe and healthy, eurozone bank equities started a rally that appeared to show that confidence had been restored in the sector and that things were gradually going back to normal. But then along came the pulverisation of the shares of Bankia in Spain. The rally kept going though, although not as much in Spain as in other pastures. A little later, one of Italy’s most venerable banks, Monte de Paschi di Siena, was at the centre of an embarrassing scandal. Investors remained upbeat nonetheless.
Then France’s Crédit Agricole announced record losses, and even a Dutch bank, SNS Reaal, went bust. But bank stocks carried on going up. Germany’s Commerzbank sent its own shares down by launching what sounded like a desperate capital increase initiative, and some have raised fears about the state of Germany’s regional lenders. Worryingly, in the German and Dutch cases, we were actually talking about those Northern European countries who thrive showering advice on their peers in the South about how to deal with their banking systems. Even then, the rally, although not an impressive one, has retained some steam.
The latest ghost to arise from Europe’s haunted banking house showed its ugly face in Cyprus, where the European authorities have broken new ground in the banking horror stakes by imposing losses on depositors to avoid that the country’s lenders went belly up. Which makes one wonder whether that double-decker bus that Morrissey mentioned in his great song is closer than we think. After all, one boundary that the technocrats have always, albeit possibly with some reluctance, respected over the course of the crises is that savings of clients, especially small ones, should not suffer directly from the mistakes made by fat cat bankers.
The creative but terrifying solution crafted to the Cyprus banking crisis has caused bank equities to wobble, but not for long, apparently owing to the tiny size of the country’s economy. Its reputation of a tax haven may also have fueled hopes that the cruel solution imposed by the troika is more an exception designed for a suspect banking system rather than a new way of dealing with bloating banks all around the continent. Anyway, it looks unlikely that the Cypriot fiasco will by itself reverse the good moment that bank equities have seen in recent months.
Investors, at least, appear not to have felt disheartened by the latest sequences of bad news.
“Banking stocks have been rallying for the past six or seven months, after the ECB said that they would support the bonds of periphery economies under any circumstances,” says Robert Mumby, the manager of Jupiter International Financials fund. “That was the message that the market was waiting for.” The launching of the seeds of an European banking union (even without the UK) and other legislative progress have also given a boost to the market.
This kind of analysis is grounded on the fundamental changes that banks have been applying to their business rather than by punctual episodes that create waves in the media. And the reality in the eurozone, at least for the moment, is one of a financial crisis that is losing steam, although the economy has not began its own recovery with much gusto.
As the European Banking Authority noted in a recent report, ever since Draghi’s statement, there have been significant improvement in funding markets, which had been an Achilles heel for Europe’s banks for quite a while. Equity and bond prices have improved in the secondary market and lenders in stressed areas have been able to issue new debt under some circumstances. Banks have even started to pay back to the ECB the soft LTRO loans that were granted them during the worst spell of crisis, in the end of 2011 and early 2012.
“The reaction of the markets to the ECB stance has been especially beneficial for the banks, as they have been able to make quite significant capital gains on the bonds that they hold in their balance sheets,” Mumby adds. “They have also been able to raise some funding in the market as a result of yields coming down. The question is, where are they going from now on? There is a balance between the return of risk appetite, but an earnings situation that remains very difficult.”
An urgent task for plenty of European banks has been to root out loads of rubbish they had accumulated in their balance sheets during the good years, at the same time they need to comply with stingier forthcoming regulations being adopted at European and national levels.
Ever since the global financial crisis started with the subprime and subsequent messes, lenders have been under pressure from regulators, investors and the public opinion to mend their ways. The message has not always been heeded, and some have resisted as best as they can to change its old practices significantly, as it was argued by a recent report by the American Congress on the losses suffered last year by JP Morgan.
But plenty seem to have concluded that there is no alternative to adapting their businesses to the new circumstances that have taken shape in the past five or six years. From this point of view, progress have been made by lenders in many parts of the continent, even though many challenges remain in their ways.
“Banks have been working heavily to improve their balance sheets,” says Nikolaus Poehlmann manager of the DWS Invest European Value fund. “They have lifted their equity bases over the last years, they have improved the ratio of equity relative to their assets. Therefore, to that perspective they have made their balance sheets much more sound.”
The cleaning up, however, also means that, by putting capital aside as they build their reserves, few banks have been able in recent years to deliver anything that looks like sustainable dividends to shareholders. The riskiest assets they are still holding are sovereign debt, which, despite the recent improvement of sentiment about the asset class in European markets, continue to look quite a bit on the toxic side. Then there is the matter of real estate loans, a problem that is not only worrying in Spain and Ireland, but also in less suspect countries like Denmark and the Netherlands.
A number of banks have been able to achieve decent returns out of corporate businesses, and sometime solid profits overall. However they have had to direct such profits to build up reserves to compensate for their murky loans portfolios. The EBA itself has stressed that, although their capital positions have strengthened in the past two years, concerns remain about how they are going to meet future and stricter capital requirements. Meanwhile investors continue to believe that the quality of the assets and valuation criteria employed by many banks are suspicious, which makes it more difficult to attract new capital.
The EBA pointed out that for all the improvements observed since August 2012, the European banking sector “remains fundamentally fragile overall.” It noted that massive central bank support continues to be a main reason while a number of banks have been able to stay afoot, as private funding sources still have some way to recover in order to provide the same level of diversification that banks enjoyed in previous years.
With so many challenges compounded, it should not come as a surprise that few European banks have been able to deliver the goods for investors of late. And even in the case of those lenders that have gone quite a long way towards putting their balance sheets in order and adapt themselves to tougher regulation, the state of the European economy hardly helps them to make enough money to put a smile on the face of shareholders.
“Banks today have probably stronger balance sheets than the markets give them credit for, but not so good earnings prospects,” Mumby says. The recent rally, therefore, could very much be related to investors looking to taking advantage of lower valuations in order to position themselves to an eventual recovery in the eurozone. “The upside for the share price could be significant if macroeconomic prospects improve,” he adds.
If such is the reasoning, what should investors be looking at while browsing the market for the right opportunity?
On the one hand, identifying a stock that is being sold at a very low price compared with its history might not be the most clever strategy. Take the case of Bankia, the Spanish bank that was created among much fanfare by the end of 2010 as a result of the merger of several regional lenders, and was listed at an initial price of €3.75 a share. In mid-March, that same share can be purchased for less than €0.30. If good news about the Spanish economy manage to improve the perspectives for the company and lift its share price by even a tiny bit, good money could be made with little initial investment.
But if one considers that the Bankia has a mammoth exposure to Spain’s zombie property market and have gone through years of politically-motivated mismanagement, even a share that costs less than a chocolate bar begins to look quite expensive. In the view of Nomura, even at a miser €0.26, Bankia’s share was well above its actual valuation on 7 March.
Poehlmann says that other things must be taken into account other than a bargain share price ir order to tap into a bank.
“The most important is a good management record,” he says as an example that many a shareholder of Bankia would like to have taken heed a couple of years ago. “And a bank that has a good franchise value, a good footprint, a strong branch and client network primarily in its home country or the markets where it is operating in,” he adds. “We are also aiming at banks with a good capital base, and we want banks that are very cash generative and can already pay sustainable dividend.”
In order to do that, banks need a better economy, and also to start lending with more gusto, something that hinges on factors that are both within and beyond their own control. But if the European economy shows signs of life, lenders could become quite a good deal for investors, as analysts from Nomura noted in a recent report.
“Looking back to 2000, the relative performance of European banks has been -15% during periods of downturn, -7% in periods of slowdown, +10% in periods of recovery and +14% in periods of expansion,” they wrote. “While there is a risk of a double dip as seen in the second half of 2012 from a brief entry into recovery in February 2012, this would suggest maintaining an overweight position in European banks while the leading indicators remain supportive.”
They also noted, however, that Asian and US banks, in that order, appear more attractive than European ones in the current market.
If the idea, however, is to put some faith on European lenders, Poehlmann says that the best opportunities could possibly be found in places where share prices have fallen the least from their peaks. For example, in the likes of Sweden, Norway and other Northern European countries.
“Nordic markets already have normal banking systems,” he says. “Banks pay dividends and are back to a normal world. In other countries, it is less and less so. Banks are still working on improving their capital base and their balance sheets when it comes to balancing risks.”
The flipside, of course, is that in their case stocks have been negotiated at what looks close to fair prices. By 7 March, according to Nomura, the big Nordic bank with the lowest valuation was Nordea, whose stock was being negotiated at 11 per cent below what the analysts believed to be its target price. SEB was 9 per cent below, while DNB and Swedbank were 2 per cent and 4 per cent respectively. Danske and SHB were already above the target valuation in Nomura’s view.
“Valuations always reflect a certain profitability,” Poehlmann says. “Nordic banks in fact are more expensive today than those in countries like Italy. But that is for a good reason. You measure banks on a price to book basis. The multiple will tell you how much you want to pay for the bank’s equity. So this is relatively to the profitability that the bank has. The more profitable a bank is, an investor will be more eager to pay a higher book multiple,” he adds.
A market that has been closely looked by investors of late is France, even though the economy is struggling and bank results have not been excessively impressive, with Crédit Agricole even posting record losses in 2012. But Nomura sees plenty of upside to the likes of BNP Paribas and Société Générale, and even Crédit Agricole could have some potential for stock appreciation after the hit it took at delivering the latest set of earnings.
“In France, the banks have done a lot,” Poehlmann says. “BNP Paribas have managed to meet the capital ratio that is being imposed by regulators. Other French banks have also done well, and they are generating a lot of cash and improving their capital bases further, although they are still lagging BNP. GDP is not much of a problem for the time being in France, so the cost of risk is well contained,” he concludes.
In other countries the situation is less conducive to optimism. Mumby notes that Spanish banks have risen lately, but that is much more because of the reduction of the perception of risk about Spain and the very low valuation to which they were submitted last year. Poehlmann says that Italian banks still have quite some work to do towards sanitising their portfolios, and the political uncertainty that has taken hold of the country since the past elections do not help a bit to guarantee a healthy future for Italian lenders.
In Mumby’s view, the key of a successful investment in European banks, apart from selecting the right stocks, lies on the extent to which the economy will pick up again. “If there is a recovery for the European economies, particularly in Spain and Italy, that would be good signal to invest in banks. If there is not, that would make investors feel more cautious,” he says.
Some banks have managed to escape from the domestic gloom by taking their businesses abroad. The UK’s Standard Chartered and HSBC are the poster boys of such strategies, but among the most successful examples are also the two Spanish giants, Banco Santander and BBVA, which have spread their tentacles in the Americas and Europe with considerable success.
However Poehlmann says that, in the current market, not even geographical diversification is a sure recipe for the success of a stock.
“Being internationally diversified is not per se an advantage for a bank,” he says. “The regulatory landscape has changed and for a bank it is becoming ever more difficult to operate in a foreign market. Local regulators are starting to impose stricter rules and requirements than in the past.” Indeed, some of the global banks have been selling non-strategic assets out of their home turf in order to raise capital and adapt themselves to evolving markets.
The secret therefore goes back to the employment of competent leaders who know what they are doing, as Poehlmann mentioned above. And all of that while European authorities do their best efforts (at least in public) to comply with public outcry about exaggerated banking bonuses and try to put a cap on how much bankers can earn. No matter what, these are the same people who will be required to take banks through one more challenge, perhaps the hardest of the lot: gaining back the confidence of ordinary people. The EBA itself has noted that banks recovering the trust of clients is a daunting task for European banks.
The latest bail out policy developments in Cyprus, with their threat of confiscating part of citizen’s savings, is unlikely to help the cause. The fact that, with few exceptions like Germany, there is little credit available for individuals and SMEs makes further dents to the image of banks. The consequences of bankers’ misbehavior also continue to take newspaper headlines by storm in countries like Spain, Greece and Ireland, where unsophisticated clients lost huge sums of money as they were convinced to invest in financial vehicles that would cause a headache to the brainiest hedge fund manager.
And let’s not even mention here the tragic case of hundreds of thousands of home foreclosures that have triggered protests and suicide attempts across the continent. What is sure today is that many people in Europe could empathise with The Smiths when they lamented in that same old classic:
“Oh, please don’t drop me home
Because it’s not my home, it’s their
Home, and I’m welcome no more…”