GJ Prasad

Author Archives: GJ Prasad

19th November 2018

🏦 AT1 – Additional (or Awkward) Tier One? | Bank Capital

AT1 – Is this sub debt or equity or what?

Someone earlier asked me a thought-provoking question on AT1 to me – why do they trade with such high yields given that the coupons are almost safe (and most likely be paid) and bonds may get called on first call date and the banks issuing them are so well known domestic names?

And I just did not know where to start and how best to put it across to that investor that the AT1 instrument is more like an equity instrument sold in a debt format and the investor has sold many options to the issuer.   Many investors have bought this instrument for its relatively high yield and debt-type features and conveniently forgotten the equity type risks loaded in the same. But frankly, I think AT1 is more a hybrid instrument with significant awkward tail risks embedded in them.


Things taken for granted – “no” coupon deferral/ “limited” call risks…

Whilst coupons will most likely get paid for most issues unless mandatory deferral clauses come into play, purely from a structure perspective, they are discretionary payments (issuer has optional discretion not to pay) and are non-cumulative in nature.

As far as the call is concerned, it is most probably an economic decision based on where the bank can re-issue / refinance the same and to that extent, irrespective of the reset spread, it is entirely possible that issuer decides not to call as market conditions are not favorable. And yes the higher reset spread on older AT1s may yet prove to be decisive in the economic decision to call.  However, the issuer may yet decide not to call the bonds and then subsequently suspend the coupon.

Will any of the current European banks dare do that anything like that?  The answer is most likely a big “no” – as it will cut the issuer from future sub-debt issuance for an extended period of time.


But, can it happen at all?

Consider this scenario in the next 12 months – The issuer has already filled the AT1 quota, has a decent CET1 ratio (and is well in excess of requirements), is in a deleveraging mode, has plenty of funding options (and hence MREL/TLAC may not be an issue) but has very poor profitability due to business model, equity shareholders have taken a bucket load of pain & equity dividends are likely to be skipped and the issuer has to incur significant restructuring charges in one go to simplify the set up.  Finally, the share price trades a huge discount to tangible discount value and market perception on the issuer about its turnaround prospects are poor.

In such a scenario, I believe that the issuer may yet consider the optional coupon suspension for the AT1 instruments to further preserve capital and/or appease equity shareholders (who may not be getting any dividends).   And that is perfectly allowed by the terms and conditions of the instrument. I would assign a very small probability to that event but if it were to happen, it may turn out to be a giant one for the asset class.

And as far as the call is concerned, good luck to those investors hoping that issuers will make non-economic decisions.


Conclusion

AT1 – is this sub-debt with equity features or an equity-like instrument with loaded options? Or just an awkward one that satisfies no one…and hence I keep repeating the same thing – AT1 needs expert/specialist handling and an extreme form of “buyer beware”.   Having said that, keeping the negative generalisation of the asset class to one side, there are enough upside opportunities in this space if (and that is a big if) proper single name selection and within that a deep dive issue level analysis is carried out.


PS – In my personal view, there are a couple of issuers that may yet fall into the situation I described above.   As always, timing is everything in AT1 investing.

15th November 2018

🏦 Banks’ Brexit Blues (BBB- negative outlook) | Bank Capital

Welcome to Banks’ Brexit Blues, negative outlook

So, here we are. The UK government agrees a draft Brexit deal with the EU and yet markets fret about the uncertainty in terms of whether it will be approved and if a hard Brexit can be avoided. Without going into the consequences of the final outcome, the UK banks that are most exposed to the domestic economy are most vulnerable and that is seen in stock price reaction for the likes of Barclays, Lloyds and RBS.

In fact, RBS is down almost 10% on fears that the bank may face an uncertain future if there is a change in government. So clearly, there is significant uncertainty coming our way over the coming weeks and hence a very clouded negative outlook.

Whilst it is difficult at this stage to be very precise about the exact negative consequences of a hard Brexit and its impact on the banks, one could carry a stress test on the balance sheets and get an idea of how much capital erosion may happen.


BOE’s stress test

The BOE is due to publish the 2018 annual stress test results on 5 Dec 2018 and that will give us more clarity on the state of capital at the large UK banks. However, last year’s annual stress test results published in Nov 2017 do give us enough insight about the capital situation.

In the 2017 stress tests, the following parameters were used to assess the deterioration in capital levels at the various institutions and if any capital actions were required:

  • World GDP falls by 2.4%.
  • UK GDP falls by 4.7%.
  • UK unemployment rises to 9.5%.
  • UK residential property prices fall by 33%.
  • UK commercial real estate prices fall by 40%.
  • UK Bank Rate rises and peaks at 4%.
  • The sterling exchange rate index falls by 27%.

Under the above scenario (very stringent in my view), in last year’s stress test, all of the banks came out well with none requiring any additional capital actions. In the test, banks incur losses of around £50 billion in the first two years of the stress. The stress reduces the aggregate CET1 capital ratio from 13.4% at the end of 2016 to a low point of 8.3% in 2018. The aggregate Tier 1 leverage ratio falls by 1.1 percentage points, from 5.4% at the end of 2016 to a low point of 4.3% in 2018.

Barclays and RBS had the biggest drops in core capital and did not meet the CET1 capital ratio “systemic reference point” using the end of 2016. But as the report mentioned, since then both banks have increased their CET1 capital ratios and hence no action was required.   Just as a point of reference, Barclays CET1 ratio has increased from 12.4% at end 2016 to 13.2% at end Q3 2018 and RBS has increased its CET1 ratio from 13.4% at end 2016 to 16.7% at end Q3 2018.   Using similar parameters for the stress test, it seems that overall losses are still an earnings event and not a solvency event for any of the large banks.

Without going into the details, RBS seems to be in the best position to handle large losses from a severe economic shock given its starting CET1 ratio followed by Lloyds and Barclays. HSBC and Standard Chartered Bank seem to fare reasonably well but that is a function of their business model (and more reliant on what happens in EM, especially in Asia)


Cocktail tail risk scenario

To me, the real question is what happens if a triple combo tail risk event were to happen in one go (hard Brexit, sharp slowdown in global growth and a full-blown EZ/EU crisis) leading to a dramatic drop in revenues and significant loan losses to be incurred over a very short period of time. In such a shock scenario, the CET1 ratios of the banks come under pressure with the likes of Barclays, Lloyds and Standard Chartered not faring that well.  Even in that scenario it seems that minimum solvency ratios are not breached but certain regulator-imposed ratios (Pillar 2 requirements, MDA for AT1 coupons) may yet be breached.


Equity may yet suffer but AT1 (in GBP) looks more worse

Clearly equity investors are going to nervous owning UK banks (especially those who domestically focused and/or have government ownership) primarily due to earnings at risk and we could yet see further drops in stock price.

It is in AT1 land (in particular the GBP issues) that I sense the biggest risk to price drop given the limited investor base and even more limited liquidity. If anything, the USD AT1 issued by Lloyds and HSBC seem the most defensive to own given the back-ends whilst the ones issued by Barclays, RBS and Standard Chartered seem the most exposed for varied reasons.  Having said that, if the USD AT1s issued by Barclays and RBS were to significantly drop in price and if yields to perpetuity were to reach 8% and above, they would be very attractive to own/add, more so relative to owning the respective bank’s equity.

In LT2 and HoldCo Senior, current valuations seem just about fair for the risks outlined but can they get cheaper and more attractive over time?  The answer is a resounding “Yes”.

Hence my title that owning sub-debt in the UK banks is like owning BBB- negative outlook paper and the transition from one set of investors to another may yet turn out to be painful, to say the least.

12th November 2018

🏦 Compare and Contrast | Bank Capital

Two EM focused banks but seen differently

Standard Chartered (STANLN) and Banco Santander (SANTAN) have similar business models in retail/commercial banking especially in emerging markets – but underneath they display very different characteristics. To some extent, both have diversified geographical exposures with a strong domestic franchise. The key difference seems to the region of focus.

STANLN is predominantly focused on fast-growing markets in Asia, Middle East and Africa which expose the bank to the cyclical fortunes of the two major Asian economies – China and India.  SANTAN is focused more in Western Europe especially in Spain, UK & Portugal and in the US & Brazil, which expose the bank to the tail risks in Europe and LATAM. So whilst STANLN is a thoroughbred in EM land, SANTAN is probably the PAN European champion retail bank that others are aspiring to be.

Just going through the numbers it is clear that SANTAN is a much bigger bank than STANLN in almost every conceivable way – total assets, total loans, revenues, net income, shareholder equity and ultimately market capitalisation (SANTAN’s market cap is EUR 69 billion versus STANLN’s GBP 20 billion).  SANTAN also delivers a higher ROTE than STANLN for the time being and is able to use its global reach to much better effect and by keeping both operating costs and credit costs low.


Equity investors seem to prefer SANTAN over STANLN

It seems that SANTAN’s better earnings track record is preferred by equity investors as seen in the year-to-date share price performance, which has been slightly better than STANLN.  And on one metric SANTAN comfortably beats STANLN and that is on Price/TNAV. SANTAN is one of the few European banks whose P/TNAV is close to 1.0 times. STANLN’s P/TNAV trades around 0.45 times, reflecting investor pessimism over growth and business restructuring.   SANTAN with its acquisition history is able to project its future growth prospects much better than STANLN.

The question for equity investors then boils down to two things:

  1. Assessing periphery-related risks versus a potential sharp economic slowdown in Asia
  2. Acquisition risks (SANTAN is a serial acquirer) versus a potential takeover target

Credit investors seem to think the opposite

But in credit land what I see is the exact opposite as STANLN debt instruments trade much better than SANTAN in terms of spreads and more importantly in terms of perception of credit risks.

Historically, both in AT1 and LT2, it seems that STANLN trades tighter in spread than SANTAN and this may be due to:

  • STANLN has much higher equity cushion within the capital structure to absorb unexpected losses
  • STANLN reports both higher CET1 and leverage ratio than SANTAN
  • STANLN is not a frequent issuer of sub debt and this helps in issuance as a rare issuer
  • STANLN is seen as a takeover prospect and potentially acquired by a larger institution
  • SANTAN’s perceived levered balance sheet and its track record of serial acquisitions

Whilst the above factors may be valid, in my opinion, I see a convergence in credit spreads between the two names as the market factors in a higher credit risk premium for EM risk especially if there is a significant slowdown in China. It remains to be seen how long that would take though to materialise.

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.

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.

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.

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.

30th October 2018

🏦 Bank Capital: Changing Perceptions

Earnings picture – More of the same but it’s all about perception from here

The European bank earnings season continues with HSBC, BNP & BBVA all reporting in the last two days. All three banks reported better than expected net income and improved operating performance relative to Q3 2017.  However, the share price reaction in the respective banks’ post announcement reflects the differing investor perception of future prospects.

All three banks have a common thread – diversified business models with a strong domestic franchise and large international presence, especially in EM. The standout feature is that HSBC is in fast-growing Asian markets where it is a dominant player and is able to use its retail banking franchise as a solid platform to cross-sell other services.

Positive jaws make all the difference

HSBC: Positive jaws

HSBC stock is up almost 5% in the last few days as the bank reported positive jaws with revenue growth in its key Asian markets comfortably outpacing costs.  With a low level of loan loss impairments, the bank delivered a double-digit return on tangible equity (RoTE) in most of its business divisions with the Retail Bank & Wealth Management Unit reporting a very strong 22% RoTE.

HSBC’s key strength permeates from its very strong deposit-taking franchise (especially in Asian markets) and this is reflected in the loan-to-deposit ratio of 73% –  hence very little reliance on wholesale markets for funding. With very little margin pressure, the bank is able to generate stable net interest income and any loan growth/cross-selling of products leads to revenue growth. Capital metrics continue to be strong with a reported CET1 of 14.3% and a leverage ratio of 5.4%.

The real question going forward is the sustainability of the very low loan loss impairment charges (Q3 18: 0.30%) and what happens if there is a full-blown recession/slowdown in the Asian markets. Pre-provision income is robust enough to handle a large spike in loan losses but earnings growth/momentum may yet be impacted. Delivering positive jaws in operating performance is welcome but it remains to be seen if it will change equity investor perception for a permanent re-rating.


FICC is in a pickle

BNP reported earnings that would have normally been sufficient to please most investors. Yet, the stock was down almost 4% post-announcement. It seems that the ongoing drop in revenues in CIB (especially in FICC business) is causing investors to reassess forward-looking earnings momentum. The key issue is – how to get revenue growth within FICC business (which is undergoing fundamental structural change) and yet keep the cost base low?  In addition, the bank’s presence in Italy and Turkey exposes it to potentially higher loan losses in coming periods. Risk management has been the bank’s strength over the years and hence is well placed to handle this.

Asset quality and liquidity metrics are holding up very well.   In my personal view, the bank’s reported capital metrics are just about fine with a CET 1 ratio of 11.7% and a leverage ratio of 4%. Further, some of the bank’s large cap global peers report much higher capital metrics, especially on leverage ratio, and the bank may yet need to build further capital buffers or reduce risk exposure in coming periods.  In my opinion, BNP used to be a very defensive play within the European banks but of late some underlying issues have crept up.


All about Turkey and LATAM

Better reported earnings for BBVA

BBVA (stock was down almost 3%) reported earnings that were much better across the spectrum with positive operating jaws and low loan loss impairments. However, earnings were boosted by a one-off EUR 633 million gain from the disposal of BBVA Chile.

Overall, ROTE of 14.8% is decent and reflects the strength of the bank’s retail banking franchise.  Asset quality continues to improve with falling NPLs and “low” cost of risk. Capital metrics look decent with a CET1 ratio of 11.4% and a leverage ratio of 6.6%. With the bank’s AT1 and LT2 buckets fully covered, the likelihood of further issuance is limited.

The real issue is the bank’s presence/exposure in Turkey and LATAM (Mexico, Peru, Columbia and Argentina). Clearly, equity investors are starting to apply a much higher equity risk premium and now seen as an EM proxy. Perception is reality in some cases, it seems.


What this means for credit folks

Purely on a standalone basis, all three banks have good credit profiles. But each one of them has separate mmacro-related issues to contend with – HSBC (potential China slowdown and Asia recession), BNP (Italy, structural issues in FICC land), BBVA (periphery spread widening, EM sell-off) and to that extent credit spread will be impacted by overall risk perception especially from an equity investor angle.

BNP and BBVA equity is trading at a big discount to tangible net asset value reflecting some of the macro headwinds and underlying business model factors. Within sub debt, it appears to me that the AT1s issued by the three banks will continue to be driven by the ongoing rates and equities volatility and market liquidity issues. Senior parts of the capital structure especially for HSBC and BNP should hold up reasonably well from a spread widening perspective.

28th October 2018

🏦 Bank Capital 🆕 (Free Content)

Welcome to the first edition of Bank Capital, GJ Prasad’s new column on CreditMarketDaily.com focusing on bank capital instruments.


It is getting tougher to please..

It has been a tough week for bank stocks globally as reflected in the almost 5%+ drop in XLF in the US and 6% drop in SX7E in Europe and it just did not matter in terms of single names.

We had a number of large-cap European banks (Barclays, DB, Lloyds, UBS, RBS) report Q3 earnings and despite decent earnings from the banks, the sector sold off on macro worries, Brexit uncertainties, Italian politics and potential disruption to business models going forward.

It seems that equity investors are starting to apprehend that banks may no longer be growth stocks but potential value traps.


A Tale of Two Investment Banks

Deutsche Bank stock was down almost 10% on the week as equity investors were not particularly impressed with the revenues trajectory especially in FICC business. Though the bank reported overall net income that was better than expected, the underlying numbers reflected the difficult state of play and the headwinds faced by the bank. ROTE is around 1.7% and the bank is targeting a 4% ROTE by 2019. Tangible net asset value is EUR 25.81 and stock is now trading around EUR 8.5, reflecting deep investor scepticism over its turnaround prospects. The cost to income ratio of 90% is just not sustainable for any bank.

Yes, revenues need to go up dramatically but the investment banking industry (and especially FICC business) is undergoing a huge structural change. Credit investors may be comforted by the healthy CET1 ratio of 14% and the sound liquidity metrics but can they keep ignoring the very poor profitability and the bank’s equity that trades at 0.34 times tangible net asset value (TNAV)?

Barclays, on the other hand, reported decent results especially in the investment bank and with a standout performance in the equities unit. Markets income is up by 19% and within that FICC up 10%. YTD ROTE at 11% (double-digit for a European bank!!!) reflects ongoing transformation (especially retreat from underperforming international retail businesses) and revenue growth in markets business.

Overall CET1 at 13.2% is decent and the organic capital generation certainly provides plenty of cushion for any Brexit uncertainty. The bank’s stock is trading at a steep discount to reported TNAV and it seems that that bulk of this discount is coming from investor pessimism on the future profitability of the investment bank.


It’s All About Brexit From Here

Lloyds Banking Group and RBS reported earnings that reflected the underlying strength of the UK retail and commercial banking industry. Lloyds continues to report solid earnings, asset quality and capital metrics.

RBS has come a long way in its turnaround story and reported very strong pre-tax operating profits with very low loan loss provisions. RBS CET1 ratio of 16.7% gives the bank plenty of options in capital management and with solid buffers well placed to handle any unexpected turbulence.


Finally, UBS also reported numbers that were better than expected and its reliance on wealth management and private banking coming to the fore. This once again demonstrates the value of identifying key strengths ahead of time and then reinforcing the advantage.

What does it mean for credit?

From a credit investor perspective, in my personal view, Lloyds and UBS are clear defensive names to own in the higher parts of the capital structure in a broad risk sell-off. RBS is now starting to become a sound credit story given its capital and liquidity metrics but the hangover of past restructuring is still there.

Barclays is an interesting example wherein equity seems to look more attractive than the bank’s AT1 purely from an upside/downside perspective. DB is clearly a case of credit investors hoping that the bank’s restructuring pays off and profitability (and more importantly revenues) improves and to that extent driven by overall market perception.