- by GJ Prasad
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.