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European banks: The slow path to normalisation

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Q4 2020 marked a gradual path back to normalisation for European banks, says Atlanticomnium’s Head of Research Romain Miginiac. Last year proved to be a real-life stress test for the banking sector, and it showed resilience beyond expectations. Capital ratios ended the year higher and shareholder payouts are back on the table.

08 March 2021

Capital – shareholder payouts, the new positive catalyst

The final quarter of 2020 saw an inflection point for European banks’ earnings, something we have been talking about since the first half of last year. While earnings were under pressure during the year, banks’ solvency exceeded estimates and the European Central Bank’s (ECB) projections. Shareholder payouts are expected to rise later this year as the ban is lifted in September 2021.

Solvency continues to be the bright spot of banks’ earnings report cards. Using our sample of banks (consistent with our previous earnings articles), the average common equity tier one (CET1) ratio increased again on the quarter to bring the average CET1 ratio to 14.2% from 13.4% pre-Covid-19. More importantly for bondholders, excess capital to requirements also increased sequentially to USD 18 billion, up close to 50% versus pre-Covid-19 levels. Banks’ resilience has clearly been above expectations, exceeding the ECB’s projections under its central scenario as part of its vulnerability analysis conducted in July 2020. This central scenario assumed a drop in CET1 to below 13%, compared to rise seen to date.

Bank capital positions have consistently improved from Q1 2020

 
Source: Atlanticomnium, bank reports, see footnote data as at 25 February 20211. For illustrative purposes only.

Given banks’ capital positions exceeded both management teams’ targets and regulatory requirements by a significant margin in the final quarter of last year, the focus has shifted to shareholder distributions. While payouts were banned in 2020 and are restricted to limited levels until September 2021, beyond that point there is a clear willingness from management teams to return the excess (above management targets) to shareholders. In theory, shareholder payouts are detrimental to bondholders by reducing excess capital, but the story has now changed. The ability to pay dividends now reflects both regulators’ comfort with banks’ business models and with the economic outlook. Therefore, as restrictions are lifted this is a positive catalyst, in our view, as it is implying more certainty on a recovery, rather than banks continuing to retain earnings. We believe this is positive news for bond holders, as equity holders will continue to take the downside. We also note that the ability to pay dividends is positive for equity valuations and will lower banks’ cost of equity, which we believe is supportive for the banks’ ability to raise equity if required, and therefore the resilience of the financial system.

Asset quality continues to surprise to the upside

In a further sign of normalisation, asset quality remained resilient in Q4 with credit losses now trending back to pre-Covid-19 levels. Uncertainty remains, with renewed lockdowns (especially in Europe) balanced by the progress of the vaccination programme and supportive new infection data. Q4 credit losses increased in comparison to Q3, reflecting seasonality as well as some impact from banks tweaking their macro scenarios. With a cost of risk of just under 60 bps, banks have provisioned less than half of peak levels in the first half of 2021 to 120 bps of loans.

Chart 2: Loan loss provisions have started to normalise in Q3 and Q4, 2020

 
Source: Atlanticomnium, bank reports, see footnote data as at 25 February 2021. For illustrative purposes only.

One key question for investors remains the future path of non-performing loans (NPLs). With government guarantee measures still in place, replacing income for individuals and providing liquidity to corporates, default rates have remained muted. Banks’ NPL ratios to date have not been significantly impacted, even modestly declining as of September 2020 to a low of 2.8% according to the European Banking Authority Q3 risk dashboard. This will inevitably rise as support measures for individuals and corporates phase out, most likely in the second half of 2021 and through 2022, although the quantum remains uncertain. Given the strong response from governments, central banks and regulators we see a more limited impact than in previous cycles. Furthermore, there has been some positive movement on the resilience of banks’ lending books. A majority of moratoria provided to customers have already expired as of Q4 2020, with the large majority of customers back to the normal payment schedule and very limited delinquencies. For example, 80% of Banco Santander’s EUR 112 billion of moratoria granted expired as of Q4, with only 3% of expired moratoria becoming non-performing, in line with its overall lending portfolio. This trend has been broadly consistent across banks, with upside surprise to banks’ asset quality.

The banks’ resilience remains underpinned by strong solvency positions and the front-loading of future expected credit losses under new accounting standards (IFRS 9), reflecting our conviction on the European financial sector. Even though there remains significant uncertainty, any need to boost provisions is more likely to lead to earnings volatility rather than threaten capital. As an example, HSBC estimates that under its most severe economic scenario a further USD 7.2 billion in loan loss provisions would have been required in 2020. This compares to around USD 9 billion of profits before tax (already including the circa USD 9 billion loan loss provisions (LLPs) taken over the year of 2020). Therefore, the group has the ability absorb the incremental impact only using profits. This reflects the sector’s ability to absorb a rise in NPLs and further deterioration in macro scenarios.

While we expect some rise in NPLs towards manageable levels, the scale of frontloading of provisions in 2020 should lead to a decline in LLPs in 2021.

Profitability remains under pressure

Fourth quarter earnings have broadly come ahead of consensus estimates, although banks’ profitability remains under pressure. This stems from retail lending activities due to the impact of lower for longer rates, lower activity in retail banking and loan loss provisions that remain above benign pre-Covid-19 levels. The relative winners of 2020 were banks with limited lending exposure (wealth / asset management focused) or those with relatively larger investment banking operations, that have benefited from market volatility and increased capital market activity during the year.

The outlook for 2021 profitability remains challenging, given lingering Covid-19 uncertainty and continued pressure on banks’ net interest margins from low rates. In the medium term we expect profitability levels for the sector to improve from a combination of aggressive cost cutting, merger and acquisitions and other strategic measures taken from banks to future-proof their business models. From a bond holder’s perspective, the key takeaway from 2020 is the ability of banks to remain profitable despite experiencing a real-life stress test scenario.

Going into 2021

As we move through 2021, we maintain our positive stance on the banking sector. Banks have demonstrated they are underpinned by robust solvency and have the ability to absorb Covid-19 related uncertainty. Investors will continue to focus on asset quality this year – closely monitoring NPL formation as well as the confirmation of a normalisation of LLPs. Stress tests will also be a key element of the calendar, with EBA expected to release results in July – providing granularity on the resilience of individual banks. Given residual uncertainty, investors should focus on banks with the capacity to absorb a prolonged Covid-19 scenario without jeopardising credit fundamentals. For this reason, we remain focused on the top European banks, be that global systemically important banks or national champions.

1Sample includes UBS, Credit Suisse, Standard Chartered, HSBC, Deutsche Bank, Barclays and Banco Santander. For illustrative purposes only.
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 no indicator of current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Reference to a security is not a recommendation to buy or sell that security. 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. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. There is no guarantee forward-looking statements will be realised.
Romain Miginiac

Romain Miginiac

Head of Research at Atlanticomnium S.A.

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