European Banks to Outperform Into the Tightening

Summary

• European banks verge on a new paradigm of higher growth and profitability after post-GFC underperformance.
• The Eurozone GDP and labour market have returned to pre-Covid strength, and loan demand should be strong ahead.
• With healthy capital levels and a solid deposit base, European banks are positioned to meet this demand.
• The ECB’s policy path paves the way for bear-steepening rates curves ahead. This will support bank lending margins.
• The fallout from Russia and Ukraine will hit names idiosyncratically. The risks to the overall sector look relatively contained.

Market Implications

• On a price basis, European banks have room to catch up with the rest of European equities.
• Post-GFC highs in RoE allow for a far higher dividend yield than broad European equities can deliver.

Low, Flat Rates Curves Hurt Bank Valuations

European banks have significantly underperformed wider European equities since the financial crisis (Chart 1). The poor performance came amid falling and flattening rates curves and during a period when many banks faced existential threats from poor capitalisation and high rates of non-performing loans (NPLs). This weakness has now largely reversed (Chart 2).

Tightening Cycle Supports Net Interest Margin

The Eurozone economy is now recovering fast, having eclipsed pre-Covid levels. Furthermore, with energy-driven inflation threatening to feed more persistently into the economy via second-round effects, as we had expected, the ECB is tightening via cutting QE while pushing back on hikes. We are entering a world of higher rates and steeper rates curves. This is important as net interest drives most of banks’ net income (Chart 3).

Net interest is a function of the difference in the cost of borrowing and the returns from lending (client spread) and the amount of lending. Because 60% of bank funding comes from deposits (much of which is overnight), the client spread largely correlates with the curve’s steepness (Chart 4). Consequently, as curves steepen, the margin banks make on their lending will rise too.

Loan and Deposit Growth Is Supportive

Meanwhile, total loan growth is expected to stay strong at around 4% pa. Deposit growth, lowering after the sharp uptick in 2020, should stabilise ahead (Chart 5). Together, banks are set to benefit from improving loan margins and strong loan volumes.

Strong Net Income to Support Dividend Yields

Elsewhere in the income statement, we conservatively assume weak investment income (on the back of the end of TLTRO positive terms). We also assume rising non-interest expenses (on the back of the talent war) and higher loan loss provisions (on the end of loan payment holidays and government support).

On the funding side, banks should be able to offset the loss of TLTROs sufficiently via deposits and additional long-term borrowing. Even with these conservative assumptions, we conclude commission fees and the improved net-interest income will be sufficient to support net income and RoE to post-GFC highs (Charts 7 and 8).

This bottom-line recovery should support a dividend yield far higher than the broader European equity space can offer.

The Fallout from the Ukraine Invasion

The fallout of the Russian invasion of Ukraine and the resultant sanctions is a significant risk. It will affect banks across several different metrics.

Direct exposure

According to EBA data, as of June 2021, European banks have relatively low exposure to Russian credit. Three major banks have significant direct exposure to Russia: Société Générale SA (SocGen), Raiffeisen Bank International AG (RBI), and UniCredit SpA (UCG). Of these, RBI has the greatest percentage of total exposure (9%), compared with 2% or less for SocGen and UCG (Chart 9).

Importantly, the Russian branches of these majorly exposed banks are locally funded. So, while impairment (or a total loss) of the Russian business could be costly to net-income, the hits to regulatory capital should be relatively capped. Only RBI is at risk of a breach (Chart 10).

Cross-border lending will also be hit. The scale of such lending into Russia, however, has already fallen significantly since 2014 to around $77bn from EZ banks.

Meanwhile, commodity producers will have uncollateralised hedges with banks. The sharp increases in commodity prices and volatility we have seen may drive the need to raise cash to meet margin calls. With regards to these hedging positions, there is little transparency from the outside. Many public traders report their positions offset and aggregated, while private ones report even less. For context, the two largest commodity traders ADM and Glencore reported exposures of $10bn in commodity derivative assets and liabilities in the last reporting period. In other words, the total size of the commodity derivative exposure is very large. The EBA provides some insight, with data on commodity market exposure by bank (Chart 11).

The offset to these potential income hits for European banks is that they have yet to reverse the loan-loss provisions they took in 2020. While US banks on aggregate took it off in a positive boost to bottom-line in 2021, European banks did not (Chart 12).

The Fallout from the Invasion of Ukraine

In sum, since the GFC, European banks have underperformed broader European equities, driven by a falling and flattening European rates curve (Chart 13). With the change in ECB tack laid out, this is set to reverse. This leaves banking on a path for net-income that should leave RoE at post-GFC highs, and provide support to sustain dividend yields decently above what the broader European equity space can offer (Chart 14).

Meanwhile, the decline in bank stocks since the Russian invasion of Ukraine looks overdone given fundamental exposures we have outlined. This then offers attractive entrance levels for overweighting the sector.

Appendix, Exposures and Announced Actions