December 6, 2023

Investment Banking

Let Your Investment Banking Do The Walking

Europe’s lenders prepare for life outside negative territory

Europe’s lenders have endured a painful decade waiting for interest rates to rise.

But just as central banks finally start to move, the long-awaited earnings windfall is being threatened by looming recession and fears that cash-strapped governments might hit lenders with new taxes.

Last week, the European Central Bank raised interest rates for the first increase since September 2011, by half a percentage point to zero. That followed more aggressive hikes at the Federal Reserve and the Bank of England in attempts to control inflation that is forecast to soon break into double digits.

“The world will have to relearn banking,” UBS chief executive Ralph Hamers told the Financial Times. “The eurozone being in negative territory for eight years, Switzerland being in negative territory for seven years now, where people didn’t value deposits, savings accounts.”

Bankers “that have joined us over the past seven years here in Switzerland, they have never worked for a bank in a positive rate environment”, he added.

The parallel developments of beneficial rate rises and harmful consumer and corporate distress have split opinion on how Europe’s banks will fare after a decade that has seen their earnings stagnate and their share prices dramatically underperform their US peers.

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Many are bullish for the first time in years. The rate hikes were hailed as a “game changer” for the sector by Morgan Stanley analyst Magdalena Stoklosa. Higher base rates mean greater profits as net interest income (NII) improves, a measure of the difference between what a bank pays for deposits and charges for loans.

“We think Eurozone rate hikes are . . . the biggest structural catalyst for European banks,” said Stoklosa. She predicts the “inexpensive” sector “sits on 52 per cent upside” to its current depressed stock market valuation.

Those with large balance sheets and loan books stand to benefit the most. HSBC, for example, sits on a global deposit surplus of $700bn and has estimated that a 1 percentage point jump in rates would generate an additional $5bn of NII annually — equivalent to a tenth of last year’s $50bn of revenue.

Lloyds Bank estimates that a one percentage point base rate rise adds £675mn to its earnings in the first year.

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Rising rates and the resultant market volatility are also good for investment banks. Barclays, BNP Paribas and Deutsche Bank have generated billions in revenue through their large trading arms as client activity has surged.

On Thursday, Barclays said revenue from fixed-income trading jumped 71 per cent to £1.5bn in the second quarter. Similarly, Deutsche Bank reported a 32 per cent quarterly rise and Goldman Sachs posted a 55 per cent gain in the same business earlier in the month.

“Whether you’re an asset manager or a corporate, a long sustained rates trend means you need to rebalance your portfolio more often, which has driven revenues meaningfully for us and the industry,” said Ram Nayak, co-head of investment banking at Deutsche.

Such optimism from analysts and investors has not been seen for years. Hamstrung by anaemic profits, misconduct scandals and higher capital requirements, major European and UK banks have traded well below the book value of their assets. Few consistently make a return on equity greater than 10 per cent, seen as the bare minimum by investors.

After the financial crisis, the region was slow to restructure and has fallen far behind Wall Street in investment banking. The lack of cash to invest in technology has left banks vulnerable to competition from fintech start-ups and big technology companies such as Apple, Google and Amazon.

However, an end to years of ultra-low or negative rates “turns their core franchise from a lossmaking prospect to neutral,” said Bank of America analyst Alastair Ryan. Based on the current projections for further hikes, BofA expects that within a year EU banks will be generating a much-needed extra €17bn in NII income every quarter.

Back to the 1970s?

But even as optimism mounts, a big question remains unanswered: how much of the interest rate windfall will be eaten by higher loan losses. Consumers face an acute cost of living crisis and small businesses are beginning to struggle with lower spending and snowballing inflation soon after global Covid-19 lockdowns.

Some believe the sector can cope, as it did during the worst of the pandemic.

“Even with slower lending, we expect the recurrent revenue benefit of higher interest rates to significantly exceed the one time impact of higher provisions,” BofA’s Ryan said.

Others are less sanguine.

“It is not easy to forecast the impact of provisions and bankruptcies. The situation is like Covid; it is completely new, we have never been through this since the 1970s,” said Jérôme Legras, head of research at investment company Axiom. “When something is unpredictable, markets have a sharp risk aversion.”

One portfolio manager at Capital Group led a €7bn sell-off in European bank stocks this year on fears that the region’s economy had turned and lenders would be saddled with vast losses and increased costs due to inflation.

Economic and political risks — such as in Italy, where prime minister Mario Draghi’s resignation has caused a crisis that has spread to the government bond market and banking system — have continued to mount.

“Recessions in both the US and Europe look increasingly likely . . . [and] history tells us that the European banking sector’s earnings typically drop 50 per cent,” said Autonomous analyst Stuart Graham.

“Current sentiment is overwhelmingly bearish,” he added. “Investors see plenty of things to worry about — principally a ‘Russia switches off the gas’ driven recession, but also 1970s stagflation, bank taxes etc — and few if any positive catalysts.”

However, there is little evidence of customer distress so far and much of the tens of billions in Covid-related bad debt reserves remain in place ready to absorb losses. European banks that have reported second-quarter results have, for the most part, beaten expectations, despite warnings of economic pain to come.

“The indicator that matters most for banking asset quality is overall employment. We need to see how that plays out, but if the labour markets continue to hold up as economists expect, credit quality should remain resilient,” Santander’s executive chair Ana Botín told the FT.

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Barclays added no extra reserves to cover bad loans in the UK in the second quarter. Finance director Anna Cross told the FT that “customers are acting in a very rational way”, for example by repaying their credit card balances swiftly.

“We are seeing a real build up of savings by consumers and corporates and a pay-down of unsecured debt, so they are going into this environment in much better shape than pre-pandemic,” she added.

Another UK bank executive said “we see no signs of strain in our portfolio yet. The earliest is usually an uptick in people only making minimal payments on credit cards, but whilst this is moving up a bit, it isn’t back to pre-pandemic levels.”

The BoE and ECB have already written to banks warning them against treating distressed customers harshly and the industry is keen not to lose goodwill it generated during the Covid crisis.

There is also the potential for more extraordinary government assistance for those struggling — as was introduced during the pandemic — which will cushion banks’ exposure to insolvencies.

“Most likely there will be subsidies to businesses struggling from energy crisis, guaranteed loans etc,” said Axiom’s Legras. “I think the public sector’s reaction will be helpful for banks.”

Easy targets

However, a widespread fear among bank executives is that higher profits will attract new levies. Spain has proposed a windfall tax of 4.8 per cent on banks’ fees and interest charges, designed to recapture some of the benefits from higher rates.

When announced it wiped billions from the valuations of the country’s five largest lenders such as Santander and BBVA. Hungary has taxed its banks while Poland is putting a moratorium on mortgage repayments to help out struggling homeowners.

“Banks are easy targets and the prospect of even more taxes is terrible for banks’ [valuation] multiples,” said a hedge fund manager that specialises in European financials. “Blaming big corporations is always a proven path in a recession to deflect from a government’s own policy failures.”

Bruno Le Maire, the French finance minister, told the FT in a recent interview he has not ruled out windfall taxes next year and that “the burden of inflation must be equitably shared between the state and business”.

The UK already has both a bank levy and a 3 per cent surcharge on bank profits, recently reduced from 8 per cent, but at risk of being reset if the Treasury needs cash.

Regulators are also moving to cut off another potential rates-linked windfall.

The ECB is examining how it can prevent banks earning billions of euros of extra profit from its €2.2tn subsidised lending scheme, which was started to avoid a credit crunch during the pandemic. Some analysts had estimated that lenders could earn a collective €24bn by depositing cheap debt back with the central bank to benefit from the current higher rates than when the loans were issued.

But, while there remains much debate over the profitability of the European financial system, few are concerned about its solvency. Recent stress tests indicate most lenders could shoulder even extreme economic strain after being forced to build substantial capital buffers after the 2008 crisis.

Some even see surviving yet another crisis as an opportunity for banks to shake off the persistent negativity surrounding them.

“A ‘good recession’ might even be a longer-term positive for the sector,” said Graham. “If the European banks can weather it with no worse than 25-50 per cent hits to earnings, no major equity raisings, no regulatory blanket ban on payouts and limited bank bashing and financial repression, this might finally lay to rest some of the lingering doubts harboured by many investors.”

“But that’s the lovely thing about European banks — you can always find plenty of things to fret about.”

Additional reporting from Owen Walker and Siddharth Venkataramakrishnan