With cheap loans returning to the European Central Bank’s toolkit, questions must be asked again about the health of the region’s banks.
8 minute read
Financial markets breathed a sigh of relief to the European Central Bank’s (ECB) announcement on March 7 it will offer a fresh round of cheap loans to euro-zone lenders via the third series of its targeted longer-term refinancing operations (TLTRO-III).
“These new operations will help to preserve favourable bank lending conditions and the smooth transmission of monetary policy,” said the bank.1
However, the news should be of cold comfort to investors. It underlines Europe’s banking sector has yet to be restored to full health a decade on from the financial crisis. That is in stark contrast to the situation in the US.
Euro-zone banks had been facing a funding cliff edge in June 2020. Between then and March 2021, €739 billion of loans of up to four years, granted under the previous tranche of TLTRO, will mature. 2
In June 2014 the ECB began offering banks longer-term loans to try to boost lending. The ‘target’ refers to the fact that the amount banks can borrow is linked to how much they loan to non-financial corporations and households.
The central bank indicated that, as with the previous tranches, banks will be incentivised to boost lending, although the terms have still to be determined.
Until recently, the ECB had been widely expected to discontinue the programme. However, with the euro zone’s economic recovery in danger of stalling, speculation a third tranche of loans would be introduced had been growing.
Too soon to lift banks’ funding costs
It its statement, the ECB slashed its growth forecast for this year to 1.1 per cent from 1.7 per cent previously, while the forecast for 2020 was also lowered.
According to Stewart Robertson, senior UK and European economist at Aviva Investors, given that backdrop it would have been premature for the central bank to have effectively lifted some banks’ funding costs.
The ECB is concerned some lenders are not yet strong enough to stand on their own two feet
“The ECB is concerned some lenders are not yet strong enough to stand on their own two feet,” Robertson says.
Although the TLTRO-II loans do not start to mature until next June, their benefit will disappear sooner. That is because banks are not allowed to include funding with less than one year to maturity in some regulatory measures of liquidity. Therefore, pressure would likely have soon started to build on weaker institutions that might have struggled to raise finance at competitive rates in the market.
Jaime Ramos-Martin, global equity portfolio manager at Aviva Investors, says although the TLTRO programme was initially conceived as an emergency measure to aid the transmission of monetary policy, many institutions have come to rely on it. That is particularly true of mid-sized Italian and Spanish lenders, which Ramos-Martin estimates could have seen earnings could drop by up to 20 per cent if the ECB had withdrawn support.
Since equity markets like “a sugar rush” and would have reacted badly if the programme had not been renewed, Ramos-Martin says it was no surprise the ECB did not want to risk disappointing them. Whether that was the right thing to do is another matter.
Non-performing loans remain high at his stage of the economic cycle, especially in Italy
“In the long run the European banking system has to be cleansed and sustainable on its own. While most banks have taken steps to fix their balance sheets, non-performing loans remain high at his stage of the economic cycle, especially in Italy,” Ramos-Martin explains.
European Banking Authority data shows Italian banks had €153.4 billion of non-performing loans on their balance sheets at the end of September, equivalent to 9.4 per cent of all their outstanding loans and advances.3
The high level of non-performing loans is among several factors to blame for European banks’ low returns. Whereas they were generating similar or even higher returns than US peers in the run-up to the financial crisis, since 2011 US banks have substantially outperformed and are now generating a return on equity of around 11.8 per cent compared with the 7.3 per cent return generated by European lenders.4
Pressure on profits sparks merger speculation
Worryingly, with interest rates set to stay extremely low for the foreseeable future, and banks under pressure to boost spending on technology to fend off fintech upstarts, pressures on profitability could intensify.
Despite a decline in their numbers in recent years, arguably there are still too many banks and branches in Europe, particularly Italy and Germany. This is viewed as another cause of low returns.5
Strangely, whereas in the run up to the financial crisis there was a healthy level of consolidation, this has subsequently dried up – except for a state-driven programme to consolidate savings banks in Spain. Banks have focused instead on shrinking and de-risking their businesses.
More recently, however, both regulators and the bosses of some of Europe’s biggest lenders have talked openly about the need for consolidation.
In December 2017, Danièle Nouy, chair of the Single Supervisory Mechanism, the ECB’s banking watchdog, argued many of the factors holding back mergers were fading away.
With growth returning and with the huge amount of work that is being done in relation to non-performing loans, we are going to see a number of mergers taking place within countries and across borders
“With growth returning and with the huge amount of work that is being done in relation to non-performing loans, we are going to see a number of mergers taking place within countries and across borders,” she told the Portuguese newspaper Público.6
Nouy, who has called for the creation of “European champions” to challenge the dominance of US and Asian rivals, added mergers were “a more positive approach” for dealing with “an oversized banking sector” than the more painful option of forcing weak lenders to fold.
Media reports have in recent months linked Deutsche Bank with German rival Commerzbank, Barclays with Standard Chartered and, in what would be a rare cross-border deal, France’s Société Générale with Italy’s Unicredit.
Frédéric Oudéa, chief executive of France’s Société Générale, told the Financial Times: “If you think ten years ahead . . . you can think about the design of the banking sector with less banks, more domestic consolidation and probably a few more pan-European banks.” 7
Negative feedback loops
The ECB is particularly keen to see cross-border mergers to reduce the severity of negative feedback loops between individual nations’ banking systems and government bond markets, since cross-border banks would be less exposed to any one nation’s debt.
However, although ECB President Mario Draghi in February 2018 called for the introduction of more harmonised rules across the bloc that would make it easier for banks to merge, potentially making them more efficient, Ramos-Martin warns the decision ultimately rests with national politicians.8
Both he and Oliver Judd, financials analyst and co-head of Aviva Investors’ credit research team, see several obstacles to cross-border consolidation. Chief among them is the long-touted creation of a European banking union, which continues to prove elusive.
Although banks’ capital and liquidity requirements are set by the ECB, there is a lingering suspicion national regulators would intervene in the event of a banking crisis and ringfence institutions. In other words, while capital and liquidity are in theory freely transferrable, in practice they may prove not to be.
“That matters because part of the rationale for a strong bank taking over a weaker rival is that in buying distressed assets, it can create immediate value for itself,” explains Judd. “If its ability to crystallise that value is constrained, there’s less incentive to do the deal in the first place.”
Pan-European deposit scheme
An even bigger hurdle is the need to create a pan-European deposit scheme. Ramos-Martin believes most European bank chiefs will be wary of conducting cross-border deals in light of the experience of Italian lender Unicredit, which in 2005 acquired Bank Austria Creditanstalt and Germany’s HypoVereinsbank.
In 2011, German regulators ordered the Italian bank to stop borrowing billions of euros from its German subsidiary. They wanted to protect German depositors and prevent their banking system being infected by Italy’s.
We see little appetite among shareholders for cross-border mergers.
“We see little appetite among shareholders for cross-border mergers. From a potential acquirer’s perspective, this has been tried before, but when trouble struck it became apparent there wasn’t one banking market. The German regulator became very protective of its own depositors,” Ramos-Martin says.
Both he and Judd see little prospect of any softening of German resistance to guaranteeing depositors in other nation’s banks until banking systems have been more thoroughly cleansed. While the primary concern is the state of the Italian banking sector, Judd says it is important to recognise Germany has done little to clean up its own banks.
He believes both countries need to more thoroughly address problems in their banking sectors before domestic consolidation can take place, which he believes is a prerequisite for pan-European mergers.
Cart before the horse
“The authorities seem to be pushing consolidation to clean up the sector but that’s putting the cart before the horse. Spain, where they cleaned up their banks before embarking on consolidation, provides the template for others to follow,” Judd says.
As of 2017, the number of banks operating in Spain stood at 19, down from 62 in 2009.9 The Bank of Spain recently called for consolidation to continue, indicating it wanted to see a similar banking system to that of Canada, which boasts just five major lenders.
It is worth remembering, however, the catalyst for consolidation in Spain was a banking crisis.
While Germany’s banking sector needs to consolidate, what is the trigger for that to happen? The history of Spain suggests it won’t happen without a crisis
“While Germany’s banking sector needs to consolidate, what is the trigger for that to happen? The history of Spain suggests it won’t happen without a crisis,” says Ramos-Martin.
Although Germany has numerous publicly-owned savings banks and co-operative lenders generating low returns, they are not short of capital or liquidity. These lenders have historically been a vital source of cheap loans for the Mittlestand – small and medium-sized German enterprises – partly because their ownership structure means they have been prepared to accept a comparatively low return on equity.
“Since some of those cheap loans are likely to disappear if the German banking system consolidates, there’s likely to be stiff political opposition. Much as the ECB would like to see consolidation, this illustrates it is ultimately a domestic political consideration,” Ramos-Martin argues.
With European banks struggling to boost profitability, the ECB probably felt it had no option other than to offer support. After all, if it had failed to do so and some banks had been unable to find alternative sources of financing, they could have been forced to cut lending. That could have been especially dangerous in Italy, which recently slid into recession.
Judd expects the loans will nonetheless be on less favourable terms. He says that is particularly true of better capitalised lenders, although few may take up the offer since ECB loans come with a stigma. As for weaker Italian banks, he believes the ECB will be under pressure from Germany and other nations to ensure any lending comes with strict conditions attached.
He explains part of the reason many of these banks are in difficulty is they used the money from the previous tranche of ECB loans to load up on Italian government bonds. Those bets have gone disastrously wrong over the past year as BTP yields rose sharply, causing mark-to-market losses. Judd believes the ECB will want to ensure there is no repeat.
According to Robertson, this adds an interesting dimension to the ongoing tussle between Rome and Brussels over Italy’s budget deficit. With its economy in trouble, it seems Italy’s populist government is itching to flout the EU’s budget rules. He wonders whether the new TLTRO programme might be used as a bargaining chip in European authorities’ battle to force Rome to get its deficit under control.
As for what this means for investors, Ramos-Martin says although the prospect is for continued subdued earnings growth for the European banking sector, this is being priced into shares.
As the chart below shows, whereas prior to the end of 2011 European banks were trading on a similar price-to-book ratio to their US rivals, since then they have significantly underperformed. The pace of underperformance has accelerated over the past three years.
“European banks are trading on a price-to-book ratio of 0.75 compared with 1.3 for US banks, so there’s an awful lot of bad news already priced in. That can be partly explained by lower returns, but even allowing for that they trade at a discount,” Ramos-Martin says.
Although a major wave of consolidation appears unlikely, if he were to be proved wrong Ramos-Martin believes there could be significant upside potential for European banks’ share prices. In the meantime, investors need to be selective.
There are some banks with good businesses and higher returns in the Nordic region and the UK, for example, while Spain is healing. Even France offers some decent opportunities, but as a general rule we would avoid Italy,
“We prefer well-capitalised banks generating higher returns. There are some banks with good businesses and higher returns in the Nordic region and the UK, for example, while Spain is healing. Even France offers some decent opportunities, but as a general rule we would avoid Italy,” Ramos Martin says.
As for Judd, he has a similar preference for banks with high levels of capital, but also institutions that have cleaned up their balance sheets since the financial crisis and have proven access to wholesale funding markets.
Spanish and UK banks fit that description, while there are also interesting opportunities in France, the Benelux region and Nordic nations. Judd believes credit investors should be wary of Italian and German banks given the uncertainties surrounding them.
- Source: European Central Bank https://www.ecb.europa.eu/press/pr/date/2019/html/ecb.mp190307~7d8a9d2665.en.html
- ECB Economic Bulletin, Issue 3 / 2017 https://www.ecb.europa.eu/pub/pdf/other/ebbox201703_05.en.pdf
- Source: European Banking Authority https://eba.europa.eu/documents/10180/2547788/EBA+Dashboard+-+Q3+2018.pdf/95e0ea7f-bd3c-443a-8b0c-084c0f4cc2bc
- Source: Bloomberg, Aviva Investors’ estimates
- According to the European Banking Federation, as of 2017 there were 6,250 credit institutions operating in the EU with 183,000 branches. There were 8,525 institutions with 238,000 branches in 2008.
- Europe’s bank bosses see need for consolidation in sector https://www.ft.com/content/810e4256-e73e-11e7-8b99-0191e45377ec
- Source: ECB, Letter from Mario Draghi to MEP Enrique Calvet Chambon https://www.ecb.europa.eu/pub/pdf/other/ecb.mep180208_Chambon.en.pdf?89b6359e002525f49f5d7316989b517d
- Source: Scope Ratings, research note published December 2017