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European banks – Russia is an equity story, not a credit story

Romain Miginiac, Portfolio Manager & Head of Research at Atlanticomnium, examines the European banking sector in the context of the Ukraine crisis and the specific impact of exposure to Russian counterparties.

18 March 2022

Despite ongoing geopolitical uncertainty and worries around unprecedented sanctions on Russia, the European banking sector marches on. Exposure to Russian counterparties is relatively contained in our view, and banks’ appetite to lend in Russia has materially decreased since 2014. Even if a tail event were to materialise – a total wipe out of banks’ Russian exposures – individual banks’ solvency levels are not threatened, and excess capital would likely remain robust. As regulators and supervisors are closely monitoring banks, the tone on shareholder payouts for impacted issuers has started to shift to the conservative side. This seems to reinforce the narrative of shareholders taking the hit, while coupons on Additional Tier 1s (AT1s) would only likely be impacted should capital ratios fall below requirements – a scenario not on the table. Banks’ subordinated debt can likely offer attractive valuations, investors benefit from high carry in a resilient sector, with potential price upside.

European banks have limited exposure to Russia, which has been drastically reduced post sanctions in 2014

Global banks’ overall exposure to Russia is low at USD 121 billion1, of which around USD 80 billion for European banks – immaterial in the context of around EUR 50 trillion of assets for the European banking sector2. This has drastically declined since the annexation of Crimea in 2014, by more than 50% (from USD 256 billion to USD 121 billion)1. Sanctions have been the key driver of banks’ reluctance to lend to Russian individuals and entities.

Consequently, a potential contagion effect is remote even in a tail scenario, reflecting the minimal exposure of European banks and the marginal interconnectedness of Russian and European banking systems.

European banks’ exposures stem from both stakes in local Russian banks and offshore lending

European banks broadly have two types of exposures to Russia, on-shore exposures via local banking subsidiaries and off-shore exposures booked at banks’ headquarters.

Banks’ onshore exposures are held in local (Russian) subsidiaries, in which the parent company has an equity stake. The bank is ultimately only a shareholder of the Russian entity, and maximum losses are limited to the banks’ equity investment (plus any potential intra-group funding). To trigger a full write-down of banks’ equity stakes, scenarios of expropriation (being stripped of ownership rights) or parents walking away from their subsidiaries (either due to insolvency of the local entity or forced by political pressure) would need to materialise.

It is important to highlight the high profitability of Russian subsidiaries, for example Raiffeisen Bank International consistently generated a return on equity above 20% in Russia over the past five years, and even 18% in 20143. High profitability equates to high ability to absorb losses, a mitigant to the current situation.

Offshore exposures are those held directly held by the parent company (cross-border), usually wholesale banking. This can include loans, guarantees, committed credit facilities, derivatives etc. In this case banks’ ultimate loss is the full exposure to Russian counterparties, net of any collateral or guarantees. Offshore exposures are clearly more problematic, as the parent company could, in a worst case, assume the full loss, rather than writing down an equity interest in a local subsidiary. An equity interest would be a fraction of loans or other exposures.

Stressing Russian exposures shows no individual vulnerabilities in the European banking system

Although European banks overall have limited exposure to Russia, the relevant question is whether any outliers are running outsized Russian risk. A handful of European banks have material exposure to Russian counterparties (both on- and offshore).

Stress testing these banks’ Russian exposures is a helpful tool to assess the ability to navigate the ongoing crisis. A highly uncertain situation calls for an extreme scenario – the assumption that banks will be forced to walk away from the Russian subsidiaries and that all offshore exposures (net of collateral and guarantees) will be written down to zero. While this scenario differs materially from our base case, gaining comfort that banks can weather the storm requires a manageable outcome in the harshest of scenarios.

To illustrate the mechanics of the stress test and its impact, Raiffeisen Bank International (RBI) is an interesting case study – as the bank with the largest Russian banking operations.

Chart 1 illustrates the impact of the stress scenario on the bank’s excess capital position (amount of capital above requirements), which stood at EUR 2.4 billion as of FY21. As RBI is mainly exposed through its local subsidiary, the bulk of losses (EUR 2.4 billion) would be the write-down of its equity stake. However, this would be partly offset by capital relief of no longer having the underlying assets – reducing capital requirements for Russian exposures (EUR 1.2 billion positive impact on excess capital). The net impact of a full write-down of the local subsidiary would thus amount to EUR 0.7 billion negative impact. Offshore exposures are relatively contained, the assumption of a full loss leads to another EUR 0.6 billion of capital impact. Hedging gains (the bank hedged against movements in the RUB) and macro-provisions offset some of the negative impact, a cumulative EUR 0.4 billion positive impact. Finally, the bank’s decision to cancel the planned 2021 dividend adds another EUR 0.4 billion of excess capital.

In the worst-case scenario, the total impact on RBI’s excess capital would be EUR 1 billion, still leaving the bank with a comfortable EUR 1.4 billion of excess capital, well in excess of requirements. This equates to a common equity tier 1 (CET1) ratio of 12.3%, 190 bps above the 10.4% requirement. And this would be despite Russia being 11.5% of the group’s loans.

Chart 1: RBI’s excess capital position remains robust even in a worst-case scenario

Source: Company documents, Atlanticomnium. As of year end 2021. For illustrative purposes only. Provided to assist the reader in understanding the themes presented.

In this case, even in an extreme tail scenario, bondholders appear to remain well protected.

Other European banks with material Russian exposure (see Chart 2 for a sample of banks with material exposure to Russia) have the capacity to manage the impact. In no case would this threaten banks’ solvency, underpinned by large excess capital positions and manageable potential losses. The range of impact on capital of a worst-case scenario is 0.8% (Credit Agricole) to 2.0% (UniCredit) as shown below, but leaving excess capital in a very comfortable 1.8% to 7.8% range. The magnitude of the impact reflects the scale and nature of exposures (offshore versus onshore).

Chart 2: European banks’ excess capital remains robust in a tail-risk scenario

Source: Company documents, Atlanticomnium. As of year end 2021. For illustrative purposes only. Provided to assist the reader in understanding the themes presented.

Once again, subordinated bondholders do not face any impact from a stress scenario

The most important lesson as bank investors from the real life Covid-19 stress test was that regulation is overwhelmingly credit positive. Shareholders took the bulk of the hit during the crisis as dividends were cancelled as a precautionary step taken by the regulator to safeguard financial stability. The treatment of bondholders was much more mechanical and pragmatic – for example on AT1s where banking supervisors made it clear coupons would only be shut off in the case of a breach of requirements.

The current situation acts as a reminder that shareholders will once likely again bear losses, and that bondholders are only at risk if solvency is threatened. Regulators and supervisors have been closely monitoring the situation and been in quasi-continuous dialogue with materially exposed banks. This has resulted in banks being pre-emptively conservative, taking the route of capital conservation at the expense of shareholder distributions. RBI has announced the cancellation its annual dividend, while UniCredit has put its EUR 2.6 billion share buy-back on hold (and potentially re-sized) dependent on how the situation develops in Russia. On the other hand, RBI has stated on a recent call that they see no scenario where AT1 coupons would be cancelled.

The European banking sector’s low vulnerability to the uncertainty around Russia and the lack of outliers to derail financial stability is likely once again a sign of banks potentially being one of the stronger sectors. Elevated volatility and negative sentiment have weighed on valuations – leading to attractive opportunities in our view. With spreads on European banks AT1 contingent convertibles (CoCos) around 450 bps, close to 200 bps wide compared to pre-Covid-19 levels4 – investors may benefit from high carry in a robust sector, combined with potential upside from a recovery in price in case the situation unwinds.

Source: BIS as of Q3 2021
2Source : European Banking Federation as at year end 2019
3Source: Raiffeisen Bank International company documents as of year end 2021
4Source: Bloomberg as at 9 March 2022
Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is not a reliable indicator of future results or current or future trends. The mentioned financial instruments and case studies are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented and are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. There is no guarantee that forecasts will be realised.

Romain Miginiac

Fund Manager & Head of Research at Atlanticomnium SA
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