Is there a path back to profitability for European banks?

Equities 7 minutes to read

Peter Garnry

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.

Source: Bloomberg Intelligence

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.

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-hk/legal/disclaimer/saxo-disclaimer)

Saxo Capital Markets HK is a company authorised and regulated by the Securities and Futures Commission of Hong Kong. Saxo Capital Markets HK Limited holds a Type 1 Regulated Activity (Dealing in securities); Type 2 Regulated Activity (Dealing in Futures Contract) and Type 3 Regulated Activity (Leveraged foreign exchange trading) licenses (CE No. AVD061). Registered address: 19th Floor, Shanghai Commercial Bank Tower, 12 Queen’s Road Central, Hong Kong

By clicking on certain links on this site, you are aware and agree to leave the website of Saxo Capital Markets, proceed on to the linked site managed by Saxo Group and where you will be subject to the terms of that linked site.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

Please note that the information on this site and any product and services we offer are not targeted at investors residing in the United States and Japan, and are not intended for distribution to, or use by any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation. Please click here to view our full disclaimer.