Monthly Archives: November 2018

8th November 2018

🏦 All about where one is based | Bank Capital

Italian or French – Does it matter?

We had Societe Generale (SOCGEN) and Unicredito (UCGIM) report Q3 earnings on Thursday and whilst the underlying core earnings story was more or less the same, equity investors were more upbeat on SOCGEN’s earnings (stock was up 3%) and less so on UCGIM (down 4%). This just reiterates the fact that investors place a much higher risk premium on Italian banks, given the sovereign linkage.

In many ways, both banks have a similar business model – well-entrenched domestic retail franchise, specialised financial services, central and eastern European presence and an investment banking focusing on niche areas.

Core underlying earnings fine

UCGIM’s earnings were impacted by the write-downs to its stake in Yapi (its Turkey subsidiary) but underlying earnings were decent with reported adjusted ROTE of 8.3%. With credit costs under control and ongoing internal business restructuring, reported earnings were better than feared.   The significant restructuring of the bank, especially in its non-core unit, is clearly having an impact on its turnaround prospects.

SOCGEN’s earnings were clearly boosted by the better performance in the investment bank especially in equities and that meant the bank reported a decent 11% on ROTE. The sustainability of the investment bank performance is yet to be established. The question is – should investors be happy with the 11% ROTE – given the bank’s presence in Russia and its specialised consumer finance business and its large equity derivatives business.

Key difference: Asset quality

Asset quality is the one area where UCGIM still suffers from investor pessimism. With its large non-performing exposure (NPE) of 8.3%, it is still a long way to go relative to its large cap European bank peers. The creation of the non-core unit to handle legacy NPE has helped in bringing down the numbers from double digits in previous years. SOCGEN’s non-performing loans are around 3.8% reflecting its loan book underwriting and credit risk management.

Capital is stretched for both but in different ways

On capital metrics, it remains to be seen if the sharp drop in UCGIM’s CET 1 ratio (almost 40 bps this quarter) to 12.1% and a similar drop in leverage ratio to 5% is a one-off.   Though the CET1 ratio and leverage ratio is much higher than many of its European peers, it is still not high enough to weather an all-out risk-off scenario either due to Italian politics and/or EM crisis

SOCGEN reported a CET1 ratio of 11.2% and leverage ratio of 4.1% which is decent and in line with French peers but in my opinion not strong enough to weather multiple headwinds. It seems that the French banks can get away with the lower CET1 and leverage ratios given their domicile and perceived fundamental strength.

Equity market reaction

UCGIM stock was down 4% today whilst SOCGEN stock was up nearly 3%. Funnily enough, both banks have experienced sharp falls in their stock prices over the year and have almost similar market capitalisation (UCGIM market cap is around EUR 25 billion and SOCGEN is around EUR 27.5 billion).  UCGIM stock is down 30% YTD and is trading at a Price /TNAV of 0.5 times whereas SOCGEN stock is down about 22% YTD and is trading at a Price/TNAV of 0.6 times. To that extent, not much to choose from but one must guess that is the reason for the constant noise that a merger between the two may make sense.


It depends on the risk premium that investors want to attach to the very similar (but slightly different) business models. UCGIM will continue to need a much higher risk premium given its Italian base and presence in Turkey and large level of NPEs. SOCGEN, which although at first glance seems less risky, probably needs a higher risk premium as well given its Russia and Equity derivatives franchise.

As far as credit investors are concerned, AT1s issued by SOCGEN are much better to own given the 7%+ yields relative to the bank’s LT2s and non-preferred senior paper.

And in the case of UCGIM think LT2s better to own ahead of its AT1s.  UCGIM’s AT1 yields (8%+ in some issues) are attractive no doubt but overall the cash price is still too high for the tail risks out there, and in the event of market anticipating a trigger, the price drop would be substantial.

7th November 2018

Lame duck… ‘ish

But no calamity… The markets liked it.  Reigning in the President got the thumbs up. The runaway express is coming under some control. There will still be executive orders, but likely no more tax cuts and the like. Growth and inflation, therefore, might moderate as any additional expansive economic policies fail to see the light […]
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7th November 2018

🏦 Mid (end of) term blues | Bank Capital

European banks – Still unloved

Whilst we wait and watch for the market reaction from the mid-term elections in the US, the European banks don’t seem to be getting any respite from the autumnal blues. A sector that has sold off almost 25% YTD and is not seeing any sustainable rebound. The relative underperformance of the European banks this year to the US financials has been stark and a reminder that investor perception matters as much as underlying fundamentals.

Most of the large cap European banks have reported Q3 2018 earnings and, despite decent numbers, there has been very little re-rating/re-assessment of the sector’s prospects by the investor community. The ritualistic EBA stress tests have been completed and we got the usual “yawn” response.

This begs the question: Are banks stuck in a structural bear market with limited upside potential or are they going through a bottoming process that will eventually lead to a stronger sector in the future? On the basis of what has been reported so far, it seems hard to expect a significant turnaround in investor optimism any time soon.

Fundamentally, reported capital adequacy metrics and funding/liquidity ratios demonstrate that the sector is a long way from the financial crisis. However, on other quantitative measures like profitability momentum (the ability to consistently generate ROE in excess of COE) and earnings at risk (for unexpected large loan losses or restructuring costs), prospects don’t look that good and that is what is causing nervousness.

Key issues to contend with

In addition to the two key issues facing the sector – low profitability due to margin compression, high operating costs and business model disruption from non-bank players – investors are focussing on:

  • complexity of legal structure and intra-group lending;
  • cross-border exposure especially in high risk EM countries;
  • level of potential impairment from holding periphery government bonds;
  • operational/reputational risks especially relating to KYC/ML;
  • reliance on cheap central bank funding.

From an equity investor perspective, at first sight, valuations across the sector seem cheap given the low Price/TNAV (trading at a large discount to tangible net asset value), attractive dividend yield and fairly priced on a price to forward-looking earnings estimates. But all of the three valuation metrics could still be questioned – is TNAV accurate? Are dividend payouts sustainable? Are the forward estimates realistic? Valuations may be cheap and attractive but markets see to be focused on the “unknowns’ and risk/issues outlined above and they are unlikely to be resolved anytime soon. Clearly qualitative factors comfortably taking precedence over quantitative measures.

And that brings me to…

The structural weakness of the European banks come to the fore when they are sliced and diced in a worst case scenario – very poor earnings profile, inadequate reserve coverage for impairments and core capital shortfall due to leverage. In such scenarios (though a low probability event), at least for some banks, capital burn is significant and whilst equity investors will take most of the hit, the AT1 instruments may yet come into play in terms of potential write-downs or conversion into equity.

This I think would be due to the issuer reaching PONV (point of non-viability) and regulator stepping in well before actual triggers come into play. This PONV is the biggest unknown qualitative factor (and one that is decided by the regulator) in AT1 valuation. Thus, single name selection becomes even more important in AT1 investing.

On a separate note, some hold the view that, given the yields, AT1 is attractive relative to other junk paper (HY and EM issuers) for similar ratings.  It probably is true in some names due to their defensive issuer profile.

But, I think the comparison is probably incorrect due to many considerations – unlike HY/EM corporate issuers it is almost impossible to model cash flows and its impact on leverage/capital structure for the banks, outsized impact of macroeconomic risks on bank balance sheets, the range of options sold by the investors to the issuers, the role of the regulator in determining viability of business and, finally, the difficulty to accurately determine the impact on capital ratios from the qualitative risks/issues discussed earlier.

It appears to me that AT1 is a strange hybrid instrument that was designed to address the issues from the previous crisis and I believe that some investors don’t fully understand the structural risks.

One thing is for sure – this asset class needs specialist/expert handling – someone who understands the macro picture in addition to having a deep knowledge of the issuer and the sector and can handle the volatility that comes from the underlying cross-asset structural features.

6th November 2018

Trump’s mid-term report

If only it were that simple… One would think that corporate borrowers ought to be champing at the bit in order to get a deal away. If only because many fear that the ECB’s QE stimulus withdrawal at year-end will necessarily result in higher funding costs. It’s not that simple because the Eurozone economy is […]
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5th November 2018

Mid-terms stifle activity

iTraxx Main

69.8bp, -0.7bp

iTraxx X-Over

288bp, -0.2bp

🇩🇪 10 Yr Bund

0.43%, unchanged 

iBoxx Corp IG


iBoxx Corp HY


🇺🇸 10 Yr US T-Bond

3.20%, -1bp

🇬🇧 FTSE 100

7,356.42, -29.00
🇩🇪 DAX

12457.70, -0.10
🇺🇸 S&P 500

3006.79, +1.03

Steadying the ship…

Let’ see what the US mid-term elections brings. It was a mixed and perhaps apprehensive start to the week, but at least we had some signs of life in the primary corporate bond market. Several borrowers emerged from the debris of the past few weeks. We have five weeks left in reality in which to get some good business done, needed in a primary market which has generally failed to deliver this year. But primary can only pick up in a material way if the tea leaves elsewhere are lined up. Otherwise, the deal flow is going to come in fits and starts, just as it has done for much of 2018.

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4th November 2018

🏦 Tail risks still wagging the European banks | Bank Capital

Single name dispersion the name of the game

It was a pleasantly risk-on sentiment for European bank stocks last week with the sector (SX7E) almost up 3% for the week.  Yet the sector saw huge volatility in price action right through as headline risks kept investors on their toes.  Also, we had very decent dispersion in price action within the sector with the likes of ING and Standard Chartered up more than 7-8% for the week on better than expected earnings and DB up almost 9% on news of an activist fund taking a 3% stake.

Overall it has been a very good week from a long/short trade perspective if the right single names were paired up. It appears that credit investors were just bystanders in this volatile market set up. Brexit, Italian politics, trade war spill-overs, Fed/ECB policy normalisation and EM turmoil are amongst the many key tail risk events having an outsized impact on future growth and revenue prospects.

Earnings still the key driver

We had a number of large cap banks report last week (HSBC, BNP, BBVA, Santander, ING, Standard Chartered and Credit Suisse). The common theme for positive stock price momentum being – generating positive jaws in operating performance.  Plus, it seems that investors prefer a business strategy that is simple to understand in terms of region or product mix and that seems to be the way forward to generate better shareholder value.  Barring a few exceptions (they are busy restructuring their operating units), overall ROTE is nudging up to 10% at a sector level. It is a pity that COE is just going up as well, as the risk premium for the sector has increased.

Stress results don’t show much stress

We had the EBA publishing the stress test results for the major European banks on Friday and, barring a few negative surprises, this turned out to be a non-event. It remains to be seen if investors think that these tests were credible enough and whether it did capture all the tail risks and the real impact on bank solvency – and more importantly, liquidity. I still think many of the European banks have significant leverage (and this is reflected in the sharp fall in leverage ratios in stress scenarios) and the significant sovereign/bank nexus means the banks are not well capitalised from an unexpected macro shock in EZ land.

Plus, we have the perennial problem of low profitability and overbanked banking systems. In addition, reliance on wholesale markets (I include ECB funding in that) is still an issue and if funding markets were to shut down, we will go back to square one. To that extent, I don’t see these stress test results changing investor perception in a material way.

Long-dated USD AT1 not that attractive to me

iShares 20+ Year Treasury Bond ETF (TLT) traded at a 52 week low on Friday at $111.90 intra-day and is down almost 11% YTD. With the long bond 30 year UST yield trading at a 4 year high of 3.46%, I believe that risk is still misplaced in many parts of the fixed income market. Despite long-dated USD AT1s having significant duration risks (in addition to other trigger related risks and tail risks) I am not sure if investors are getting paid enough to own some of the potentially “perpetual” issues with low coupons/low reset on non-call.

And remember, AT1 instruments generally trade on a cash basis in secondary markets and hence the notion of hedging interest rate risks almost non-existent for many investors. Also, most dealers don’t trade this on spread) and hence hedging the same has its own problems. To hedge or not to hedge is not the question – but what to do next with this instrument here?

Is bank debt a defensive play for now?

The earnings picture from the banks that have reported so far indicate that the health of the banks is definitely in much better shape than perceived. Asset quality metrics look solid and that is a function of the benign credit conditions in Europe. Capital ratios are ticking up with CET1 ratios moving towards the teens (there are some surprises, though) but leverage ratio is still a work-in-progress for the larger banks with bigger investment banking units. But, if any of the tail risk events were to materialise, earnings momentum is at risk for most of them and hence equity investor apathy.

Sub debt is always going to trade on the back of equity performance and investor perception and hence unlikely to materially tighten in spread terms but may outperform equity. It appears to me that Non-preferred senior bonds issued by the larger banks are starting to become attractive as defensive plays to fund shorts in other parts of the capital structure and/or across names.

To summarise, bank capital investing is much more interesting from a relative value perspective and to some extent this strategy takes out the directional risk element.

It may be safer to play that way until the clouds disappear.

4th November 2018

Still trading the headlines

Must be time to look ahead to 2019!… A line in the sand drawn for a new month and a new start?  The chance would be a fine thing! It looked like we were off to a flying start for November, but we failed to maintain the improved tone even after a solid non-farm payroll report. Equities […]
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1st November 2018

🏦 Bank Capital: Clouds lifting for some

Know your commercial (KYC) banking

We’ve had two banks – Standard Chartered and ING – that have been under market spotlight for KYC/ML related issues & reported earnings and, in both cases, the underlying core operating performance in the retail/commercial banking units stood up well. And equity investors seemed to like what they saw while credit investors are still pondering about macro issues.

Becoming Standard (STANLN) Again

Standard Chartered Bank (STANLN), the EM specialist with a UK base, reported much better than expected earnings primarily driven by broad-based revenue growth and tight cost control. Underlying profit before tax was 25 per cent higher and statutory profit before tax (which includes restructuring and other items) was up 35 per cent.  Another Asia-focused bank reporting positive jaws in operating performance.

Similarly to HSBC, STANLN’s strength is its retail banking presence in fast-growing Asian markets with a solid deposit franchise and any pick up in lending results in decent pre-provision income. Customer loans-to-deposit ratio of 68% is where the strength of the retail banking franchise comes from. Though overall profitability is still relatively low to the double-digit returns in yesteryears, it seems that the bank is starting to deliver decent returns (ROTE of 7.5%).

STANLN reports a CET1 ratio of 14.5%  – a big improvement from 13.6% reported at the same time in 2017 reflecting organic capital growth and reduction in RWAs. A leverage ratio of 5.8% is strong to absorb any unexpected large loan losses from an economic slowdown in its key Asian markets.

From a credit investor perspective, although the bank’s fundamental profile continues to improve, the risk premium for EM exposure is what is going to determine valuation in terms of spread. And equity investors will probably want to see further stabilisation of the earnings momentum to re-rate its valuation.

Keep (ING) it Simple

ING: Stock up almost 7%

ING reported Q3 earnings this morning and investors seem to like the simplicity of the underlying business model and overall ease in understanding the drivers of earnings. The bank’s stock was up almost 7% on the day despite the bank taking a large EUR 775m in settlement charges as underlying operating profits before taxes increased by 6.5% on a year-on-year basis.

With a cost to income ratio in the mid-50s area and cost of risk substantially subdued at 27 bps, the bank was able to deliver a solid set of pre-tax operating income and a ROE of 10.7%. But for the one-off settlement charges, this would have been an even better quarterly report.

As they say, sometimes, keeping it simple is the best strategy. ING focus is on its domestic Benelux markets and within that retail banking allows it to generate decent returns on equity but with good capital metrics. With a CET 1 ratio of 14% and a leverage ratio of 4.2%, the bank is well placed to handle potential downside risks. In addition, the estimated annualised pre-provision income of almost EUR 8 billion allows the bank to absorb unexpected spikes in loan losses.

After years of internal restructuring and unwinding of the bank assurance model, the bank is finally starting to show the benefits of its simple yet powerful business model. It is one of the few examples amongst European banks wherein AT1 looks attractive to own/hold given the defensive nature of the bank’s business model and ongoing capital buildup.

From a credit angle, especially in senior and LT2, ING is going back to its earning its “boring but defensive” tag.