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Daily Archives: 4th April 2019

4th April 2019

Think European Bank Capital is boring? Think again (Free Content)

It’s just the opposite…if you look carefully

I can empathise with those who think that investing European bank capital is not that interesting given the plethora of negative news and it is the usual story of missed opportunities, sovereign bank nexus and difficulty in estimating recurrent earnings etc.  Plus, the ongoing issues around business model, KYC issues and reliance on wholesale funding.  So one could easily conclude that there is hardly anything to get interested in.

However, there are a quite number of interesting idiosyncratic stories to focus on and potential trade ideas to consider.

Within European IBs, plenty of dispersion

Low global growth prospects in and Brexit uncertainty means that earnings estimates may yet be a bit high for a number of large-cap European banks.  And some banks have already announced further cost costs to improve returns.  Yes, on the margins the cost cuts help improve overall returns but the underlying issue is of revenue growth and the need to transform the business model (in the era of technology-driven disruption).  And in that context, the European IBs have significant work to do in terms of strategy and business rationalisation.  There is a significant relative value proposition in the AT1s issued by the UK and Swiss banks with large investment banking operations.

Some are perceived better than others

Amongst the periphery banks, Santander has always enjoyed a better investor reception due to its ability to deliver earnings.  But, this is a bank with significant operations in Brazil, UK and consumer finance and one wonders if the bank’s CET1 ratio is on the lighter side relative to its peers with a similar business model.

It’s very interesting to note the bank’s CEO comment that they think the current capital rules are too tough and that investors and analysts should lobby the ECB to loosen it.  I would argue that the bank’s AT1s are much more attractive than its equity purely from a valuation perspective.

Core EZ plays but with significant EM franchises

Austrian and Belgian banks have benefitted from their Core EZ domicile but they do have significant CEE exposures.  Amongst the Austrian banks, Raiffessein Bank International’s AT1s have been impacted largely due to its Russian exposure and money laundering issues and to some extent reflect the uncertainty around those two issues.  However, the AT1s issued by Erste Bank and KBC don’t seem to have been impacted that much despite both banks having large CEE operations.   And more so on the low coupon, low reset AT1s.

Euro Zone growth prospects getting dimmer

Without a doubt, an Italian recession or political crisis will have a significant impact on the Italian banks given the amount of government debt they hold and the ongoing reliance on ECB for funding.  And these issues are well documented and no real surprise and hence no point in pretending otherwise.

It seems to me that credit market (especially subordinated debt) investors seem to perceive that the French banks are in a much better position.   I would argue that perception is misplaced to some extent and that they carry significantly higher tail risks in the balance sheets.

All the three major French banks (BNP, SOCGEN and Credit Agricole) have significant issues to contend with – slowing domestic and Euro Zone growth, significant cross-border exposure especially to periphery and EM,subscale investment banking business with high operating costs and more importantly, running leveraged balance sheets.

KYC / ML issues haunt the Nordic banks

First it was Danske, then came Swedbank and now Nordea and suddenly the money laundering scandal issue is starting to look systematic in the Scandinavian banking system. All three banks are very well capitalised and hence in a good position to absorb any large settlement / remedial costs, but the impact on earnings is likely to be substantial and the uncertainty means modelling any earnings estimates likely to be very difficult.

Add to this the pressure on interest margins (given the accommodative monetary policy in Europe) and ongoing disintermediation by new FinTech players, the ability of the banks to generate decent ROE is questionable.

AT1s issued by Scandinavian banks trade very tight on spread basis given their flight to quality status in the past and high reported regulatory capital ratios.   The risk premium demanded by investors to hold the AT1s issued by the Scandinavian banks seems low and I would expect re-pricing.


Last but not least

An FT article is saying that Unicredit is preparing a rival bid for Commerzbank if the DB merger does not materialise. Potentially this makes more sense given Unicredito is already in the German market through HVB and combining HVB with Commerzbank will create a national champion.

Unicredit is Italy’s largest bank

But the real question is – will the German politics allow the combined bank to be owned by an Italian bank? If yes, it would be a big thing for cross border deals in EZ and a proper banking/capital market union beckons. And if no, then back to square one.

As the article says, other banks will be interested (BNP/SANTAN) and to that extent, Commerzbank equity has more upside. But for credit investors, it is a bit more nuanced. If Commerzbank does end up within a Unicredit set up, potentially a higher risk premium may be demanded by investors.

Depending on how it is structured and how much Unicredit end up spending, their capital ratios may come under pressure given the bank’s presence in CEE and Turkey and, of course, in Italy.


Conclusion

Bank capital instruments (AT1 in particular) are high yielding but also come with significant volatility in form of tail risks.  And every bond, every issuer has something unique that distinguishes it from others and hence needs plenty of deep-dive work. In addition, unlike corporate entities, cash flow modelling does not work as investing in financials requires a good understanding of macroeconomic events and tail risks.

That is what makes bank capital investing so interesting. There is never a dull moment.