Is there a path back to profitability for European banks?
Head of Equity Strategy
Summary: European banks hit a new low point last week hitting the lowest levels since 1987 as investors seem to have given up on them. Falling profitability and a clouded narrative in Europe due to the ongoing uncertainty over Brexit and Covid-19 have pushed valuations to the lowest levels since 2002. The question is whether European banks represent an interesting contrarian trade for those that are willing to see through the Covid-19 crisis and bet on digitalisation to improve profitability despite a low interest rate environment.
Nobody likes banks it seems and especially European banks down 35% this year as the Covid-19 pandemic has caused net revenue to decline but also deteriorating collateral values of loans as certain sectors have seen their activity plunge due to strict lockdowns. According to the Eurocoin Growth Indicator (a real-time Eurozone GDP tracker by Bank of Italy) economic growth is currently -2.5% annualised in Europe which is better than the US which is estimated to be around 4.5% annualized as of September. However, a resurgence in Covid-19 cases and a looming hard Brexit have soured the mood of foreign investors sending European banks down to the lowest price levels since 1987.
In total return terms the industry has returned 1.8% annualized since 1986 compared to 6.8% annualized for the European equity market during the same period. Banks were in line with the overall equity market performance in Europe from 1986-2007, but since the financial crisis in 2008 European banks have underperformed significantly and never really recovered. As we have covered before in our research the three main issues for why European banks have failed to perform are 1) ECB never paid interest on excess reserves as the Fed did thus a backdoor recapitalization never happened, 2) Europe’s governments chose to focus on austerity in years post the financial crisis partly due to faulty euro construction, and lastly 3) the lack of mergers between European banks which could have created cost synergies and thus improved profitability.
Can European banks get return on equity back to 2019 levels?
Yesterday’s 5% move in European banks which were partly driven by HSBC which got a confidence boost from its largest shareholder Ping An Insurance Group increasing its stake in the bank but also verbally supporting it. There is informational value in such a big move, and it begs the question whether institutional investors are finally committing to the industry.
First there is the valuation argument although it has been used so many times. The price-to-tangible-book (PTB) reached 0.54 in August and dipped below 0.5 in September, the lowest on record since 2002. It reflects obviously terrible current conditions for European banks which have a combined 12-month rolling return on equity (ROE) of 1.7% as of August and could likely go negative by December or first quarter 2021. However, equity markets should be forward-looking and the PTB ratio should reflect expectations for return on equity. Given the low ratio the market is assuming a depressed ROE below the cost of equity (investors’ required rate of return on banks) for the foreseeable future. Is this a realistic assumption?
Newton’s Third Law states that for every action, there is an equal and opposite reaction. While this is a physical law in principal it holds in business as well. Banks will not allow net revenue to fall and profitability to remain at 0%. Banks will naturally cut costs aggressively as they know the market wants a ROE of 7-8% to be viable. Our view is that banks over the coming years will cut their way back to 7.5% ROE as they had in 2019 which by the way was a negative interest rate environment. Banks will have to rely more on fees for services instead of net interest margin going forward and thus asset management, wealth management and digital services will become crucial in lifting profitability. If European banks can get back to 7.5% ROE, then there is a potential for the industry to double in market capitalization driven by a rebound in the PTB ratio to around one reflecting stable profitability to cost of equity.
Consensus estimates suggest €100bn less in net revenue combined over FY20 and FY21 which is an 8-9% drop. The problem is that operating expenses are only estimated to be down by €34bn over those two fiscal years. In other words, European banks must get more aggressive on cutting costs which will likely accelerate in Q4 and beyond. However, the need for investments in digitalization will offset some of the cost-cutting in the short-term, but longer-term digitalization of banks will drastically reduce costs and make the industry more profitable despite the low interest rate environment.
The key risk here is deflationary pressures further destroying net interest margin at European banks and the failure of policymakers to revive economic growth. In such an environment loan growth and profitability would remain low and hold the price-to-tangible-book ratio down for the entire industry. If the industry does not consolidate over the coming year that would also be a headwind for the industry in unlocking profitability as banking is naturally volume game as the business scales well on its fixed-cost base and infrastructure.