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.


Conclusion

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.

GJ Prasad

A senior European bank research specialist with significant breadth/in-depth sector knowledge, GJ has researched bank capital instruments extensively - having covered the asset class for more than 15 years as an analyst and 7 years as a risk taker in buy-side roles. His specialisation includes carrying out detailed financial modelling work on the European banks focusing on asset quality, earnings and capital adequacy metrics. His deep-dive work focuses on single name selection and extensive risk analysis on capital securities, especially on structural features, issuer credit profile and equity/AT1 valuation.