European Banks to Outperform – The Trend Has Turned

Summary

• After more than a decade of severe underperformance and restructuring, European banks are verging on a new paradigm of higher growth and higher profitability.
• Eurozone GDP and the Eurozone labour market have returned to pre-Covid strength, and loan demand is expected to average c.4% growth pa in coming years.
• Now European banks have healthy capital levels and a solid deposit base, they are well positioned to meet this demand. Meanwhile, the ECB’s policy path has paved the way for bear-steepening rates curves ahead. This will support bank lending margins.
• Together, this means higher net income, a return to post-GFC highs in RoE, and a far higher dividend yield than the broader European equity market can deliver.
• We see Euro Banks having the momentum to outperform the index by around 35ppt ahead, sufficient to bring the ratio of Stoxx600 Banks to the broader index up from 0.3 to 0.45 – levels last seen in 2018.

The Macro Backdrop

The macro picture is clear: the Eurozone economy has bounced back strongly. Q4 2021 data shows economic output has now matched the pre-pandemic highs, and the labour market has returned near historic tights (Chart 1).

Meanwhile, inflation continues to surprise to the upside. Even assuming the energy price spike is transitory, headline CPI is set to remain decently above ECB targets out to 2023 (Chart 2). Meanwhile, a constant oil price would keep it above 2% even further out (see ECB board member Isabel Schnabel’s recent speech).

The ECB’s policy path is clear. Hawkish arguments on inflation are receiving increased attention, and the continued tightness of credit spreads means a tightening of financial conditions is now palatable. The market is now aggressively pricing 30bps of ECB hikes in the next 12 months (Chart 3). That is probably too much, but regardless, the direction of travel is irrefutable.

Since the GFC, European Bank stocks have significantly underperformed the broad equity index, particularly since 2010 (Chart 5). Relative performance has correlated closely with EUR 5Y swap rate (a proxy for medium-term interest rates across the bloc) since then (Chart 6).

With rates now rising into the tightening cycle, a broader based catch-up in banking stocks is on the horizon.

What Does the Macro Situation Look Like for Banks?

Changes Since the Crisis

After the GFC, the weaknesses of the European banking sector were laid bare. A poorly collateralized system with weak balance sheets and limited visibility on exposures compounded the bloc’s economic issues.

However, the situation has greatly changed since. Capital ratios have been shored up (Chart 7), and non-performing assets have been provisioned for or else offloaded (Chart 8). While profits remained subdued in the years since (due to the interest rate environment), the improved balance sheet strength and the concerted cost reduction have left them in a strong position to capitalize on the situation ahead.

Overbanking has also been an issue raised for some time. The consolidation of the sector remains limited, with individual countries continuing to jealously guard their national champions. Domestic deals have instead gained traction since the pandemic (Caixa/Bankia, Intesa/UBI etc.).

However, progress is being made. The ECB has renewed conversations on the topic, having finalized its supervisory approach to consolidation last year. This included recognition of ‘negative goodwill’ (i.e., acquisition values below book value) as capital. While we envisage no rapid turnaround in the trend of cross-border M&A, the risks are certainly skewed to the upside.

How Does Borrowing and Deposit Demand Look?

Overall, lending growth remains strong, with households having led the charge, even while loans to non-financial corporates (NFCs) flattened through 2021 following the 2020 spike. This NFC spike was driven primarily by short-term funding to finance inventory and working capital through the supply-chain bottlenecks, so the normalization was expected. NFCs now sit on relatively high cash and debt positions, leaving households to drive demand going forwards.

Looking ahead, European Banking Authority (EBA; see here) surveys now estimate that out through 2023, the rate of growth of household and NFC loans will continue at c.4% pa – decently higher than the average c.1% pa since 2010.

Within this mix, borrowing has shifted increasingly into the fixed rate space (NFC floating rate borrowing fell from 90% in 2010 to <80% in 2021, while for households it fell from 60% to 30%) and to the longer term.

Since 2002, household borrowing has been increasingly driven by mortgages (rising from 65% in 2002 to 78% now). This process has accelerated since the pandemic. Meanwhile, >5Y maturity corporate borrowing has risen from <50% to >60%, and <1Y maturity corporate borrowing has fallen from 35% to <20% over the same period.

On the deposits side, 2020 also saw a notable surge, particularly from NFCs (Chart 10). The EBA assume c.6.7% growth in deposits from 2021 and 2023, helping shore up a strong loan/deposit ratio.

This should ensure continued access to cheap funding for banks, supported by the term structure. Since around 2012, the trend has been for both companies and households to increasingly store their deposits overnight rather than at an agreed maturity or with notice (O/N rising from 40% to 60% in households, and from 65% to 85% in NFCs). As curves steepen, this trend could reverse somewhat. But the high current proportion held overnight and the gradual reaction to curve steepening should keep funding costs cheap.

Taking this together, bank lending is trending towards longer duration and more fixed. Such aspects could drag on the legacy client spread (rate on lending less rate on deposits) in a rising interest rate environment. However, with the macro conditions pointing more towards bear-steepening Euro curves, this mix of lending may offer support ahead, particularly as banks continue to fund themselves cheaply in predominantly short-term deposits.

In short, banking lending has good room to grow over coming years, supported by the rebound in the economy and growth in demand for fixed investment. Meanwhile, cheap funding in the form of deposits should remain available throughout that period.

One offset to this is the maturity (and likely early repayment) profile of targeted longer-term refinancing operations (TLTROs) from the ECB. The positive terms of the TLTROs provided a near-term uplift in banking bottom-lines. The most favourable term period is set to end in June, meaning a large portion may be paid back early. Nevertheless, even without potential tweaks to deposit tiering terms by the ECB to offset this, we do not expect the loss of TLTRO income to significantly derail the recovery.

Meanwhile, on the balance sheet side, the lost TLTROs will need replacing. We expect that the almost €1.7tn of TLTRO maturities in 2023 (Chart 11) will be offset by the rise in deposits, alongside increased debt issuance (Chart 12).

European Banks – How Do They Make Their Money?

So, combining this macro picture, how do the banks themselves look? We should first understand how the European banks make their money.

Aggregating the annual financial accounts of the largest EZ banks (c. 90% market cap of EuroStoxx600 banks), we have broken down the combined income statements and balance sheets to model and forecast the biggest drivers of banking sector net income.

Unsurprisingly, we find the largest positive drivers are interest income, commissions and fees, and investment income. Meanwhile, the largest negatives drivers are non-interest expense, interest expense and loan-loss provisions(Charts 13-16).

Interest Income and Interest Expense 

The total interest received by banks is a function of both the amount of lending and the underlying interest rate received from this lending (itself a function of the yield curve, the type of lending securitisation, etc., and the term). 

Similarly, the interest expense (cost of capital) is a function of the balance of deposits held at the banks, the amount of borrowing from other sources (including the central bank and borrowing), and the interest rates on these sources.

Feeding in our prior noted macro forecasts on lending growth and deposits, the expectation is for strong loan and deposit growth ahead, with the mix of lending and deposit terms providing support to client spread (the difference between avg. loan interest rate, and avg. deposit interest rate).

We can see below (Chart 17) that EZ client spread has moved roughly in line with the spread of 5Y EUR swap rate over ECB depo rate (an approximation of medium-term lending funded in the short end).

With ECB policy pointing towards steepening curves, we expect strong support to bank net-interest margins. Alongside sustained demand for borrowing (as per the recovering economy, and the EBA forecasts), this should feed into strong growth in net interest income.

Investment Income, Commission and Fees, and Trading Securities

Similar to interest income, investment income is a function of both the amount of total investment assets and the return received on that.

Chart 18 shows total investment assets on the major banks’ balance sheets have remained roughly flat since 2010 (in the €5.5-6.5tn range). Meanwhile, average earnings on those assets have moved approximately in line with the EUR three-month swap (in the graphs below, three-month Euribor and EONIA are used to provide longer time series).

The period of outperformance (2014 onwards) coincides with the introduction of TLTRO and net ECB asset purchases. Both are running down in the coming years, while short-end EUR rates remain anchored. This should leave investment income to remain subdued ahead – albeit with the potential for a delayed spike in 2021/22 on the back of the TLTRO drawings in 2020 and 2021.

By contrast, commissions and fees income, which appears to closely track total loan assets, is expected to remain supportive ahead as loans growth remains supported (Chart 19).

Finally, trading securities income has remained roughly flat since 2013, with a seemingly negative correlation with market volatility (we have used EuroStoxx60 volatility in the below, but the same correlation roughly works with VIX or MOVE). Looking ahead, we take a neutral assumption for a flat profile.

Non-Interest Expense and Loan-Loss Provisions

Non-interest expense is the largest negative component of the income statement, largely comprising salaries (c.30% of the amount) and general/administrative expenses. On this basis, we assume the non-wage element (c.70%) will remain stable, similar to the pre-COVID period, while the wage portion sees upward pressure on the back of the so-called ‘talent wars’ currently being waged among banks.

We err here on the pessimistic side, given that (as 2020 showed) there are significant potential cost reductions possible because of (for example) branch reduction and digital banking. The pandemic gave both significant momentum.

Meanwhile, loan-loss provision provided a large, negative impulse in 2020 on the back of the COVID crash. But the slew of defaults that was expected then has largely been avoided. Bank 2021 accounts are already showing this reversal, while (as mentioned previously) NPLs remain manageable.

Again, we take the pessimistic approach because the underlying picture is hard to see given payment holidays etc. across Europe. It seems clear from corporate earnings that, overall, asset quality has deteriorated in the bloc through the spate of lockdowns and social distancing.

This could therefore mean an increased requirement for loan-loss provisions through 2022 as government support fades and the pandemic’s longer-term effects begin to bite. This will likely disproportionately affect southern European lenders, given the relatively smaller provisions booked there in 2020 and their more generous payment holidays.

Bottom Line 

In sum, growing lending alongside improving bank interest margins should strongly support banks’ bottom lines, generating post-GFC highs in RoE (Chart 22) and the capacity for significant expansion in dividend payments (Chart 23). This should contribute further to the sector’s dividend yield becoming increasingly attractive compared with the broader European stocks index (Chart 24).

Within our framework, we see capacity for relative outperformance in Banks of c.35%, sufficient to bring the ratio of Stoxx600 Banks to the broader index up from c.0.3 to 0.45 – around the level seen in 2018.

Risks to the Outlook

We have aimed to limit how many contingent assumptions could go awry through a relatively conservative look at the sector. We assume little growth in M&A activity, relatively high loan-loss provisions ahead, rising salary costs from talent wars, and no further support from the ECB via deposit tiering.

Nevertheless, risks to the outlook remain. For the ECB’s policy path, the rate of deposit hiking could be brought forward. However, given the sequencing of policy tightening they have set out (net-APP ending before rate hikes), this would suggest faster curve steepening, which should still support Bank lending margins.

A pausing of the quantitative tightening is the main risk to the view. However, we do not see this happening without a serious blow-out of sovereign and credit spreads across the Eurozone. On this basis, Italian political risk remains a known unknown. Polling currently suggests next year’s election would see a concerted move to the right.

However, whether this would be sufficient to provoke ECB reaction is unclear. At the 2018 election, when M5S and Lega (both Eurosceptic parties) together took a majority, BTP/Bund spreads blew out. But credit spreads elsewhere remained relatively contained, and the ECB took no explicit APP action. This time, the parties are looking less explicitly ‘Italexit’ (even with the rise of FdI). Similarly, the retention of Sergio Mattarella as president provides a moderating force.

Similarly, a Europe-wide recession would also derail our forecast. With inflation only really an issue right now due to the energy-price spike, a demand-driven recession would most likely drive a return to easing in central bank policy. This, in turn, would mean a return to the market pricing ultra-low rates and to yield-curve flattening – both would be painful for the banking sector.

As it stands, the likelihood of recession right now is relatively subdued given the bloc has only just recovered from the last one and still has fiscal support to come (Chart 25). While the Q1 Omicron shock is still to enter the data, the outlook now looks pretty positive (as per our macro section).

Henry Occleston is a Strategist, who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)