15th January 2019

Steady, Stable, Sound – thus far | Bank Capital Insights

Decent start to US bank earnings

We had three large US banks (Citi, JPM, Wells Fargo) report Q4 2018 earnings and there were similar attributes in terms of earnings, outlook and similar comments on the state of the US economy.   All three reported sound increases in year-on-year earnings though they fell short in terms of market expectations/forecasts.  All three banks reported ROE close to double digits and reaching their COE.  Also, asset quality and capital metrics look robust and well placed to handle any unexpected sharp economic slowdown.

But, having said that, what is clear is that FICC business is becoming more and more difficult to make decent returns and this despite the massive volatility in rates and currency markets in Q4 2017.  JPM’s 21% drop and Citi 16% drop in FICC does not bode well for other investment banks that are reliant on FICC revenues.

To me, FICC and within that, credit markets, are in structural decline and activity levels are dropping either due to regulation, withdrawal of liquidity or simply lack of two-way flows.  It is difficult to replicate the Equities markets automation/technology driven set up in Credit given the numerous issues for a single issuer and price discovery becomes difficult.  It seems that only fittest will survive the FICC slowdown and more costs need to be taken out.


Credit profile continues to be solid

Based on the results, the credit profile of the three banks continues to reflect good profitability, sound asset quality, strong liquidity and capital adequacy metrics.  If anything, the reported leverage ratios are above 6% reflecting the strength of the balance sheets.

Capital distributions are running high and close (or higher) than 100% (Citi and Wells Fargo) but this is to be expected given that they passed the recent stress tests well and the CCAR distributions have been signed off by the Fed.  It is the supply of TLAC debt that may be an issue but given where spreads are, and I think there will be decent demand to absorb the same.   The question is: Will new issues re-price existing secondary market paper?

Citi’s much higher exposure to emerging markets, lower than peer average ROE (9.4%) and much higher payout ratio (110% of earnings), are potential drawbacks and hence need additional risk premium.

Of the three banks reporting on Tuesday, JPM continues to be the best in class in terms of earnings profile, diversification and conservative capital build up.


European economic data continues to be poor

On Tuesday morning Germany posted 2018 GDP growth of 1.5% (bang in line) – the lowest level in the last 5 years.  Given this, I don’t see how the ECB will be able to raise rates (even bring the depo rate from -0.40 bps to zero) any time soon. Whilst I don’t see any significant upside value in any of the EU bank stocks, the picture is completely different for sub debt especially the high yielding AT1s and LT2s (on a spread basis) issued by the large national champion banks with significant buffers and who have completed their issuance.

With 10 year bunds where they are, investors are getting paid for the risks in sub debt issued by some of the well capitalised and highly dominant pan European banks. To me, the current malaise in the European banking system is still an earnings event for most of the banks and hence equity should continue to be under pressure. There are some very attractive AT1/LT2 bonds to buy and hold (based on single name selection and deep-dive work on the individual bonds).


Conclusion

The divergence in the earnings profile between the US and European banks continues and it does not seem that it will converge anytime soon. To that extent, US bank stocks should outperform the Europeans for a while.

But, in credit, it seems that the better opportunity may be in the higher yielding subordinated debt issued by a select set of national champion European banks who have similar “fortress” balance sheets and benefit from very strong domestic franchises to take advantage of.

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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.