Highlights

  • Euro area bank profits are driven more by economic growth than monetary factors. This growth link explains the close correlation between the relative performance of banks within the euro area and the relative performance between euro area and U.S. equities. It also highlights the importance of euro area banks to global asset allocators.
  • Euro area banks now have attractive valuations, which are offset however by a lackluster profit outlook. Long-term investors should avoid banks in the region.
  • Investors with a more tactical mandate and much nimbler style could use our valuation indicators to “time” their entry and exit into banks as a short-term trade.

Feature

Banks in the euro area have underperformed the region’s broader market by about 50% since March 2009, when global equities reached their financial crisis lows. In the same period, the overall euro area equity index also underperformed U.S. equities by about 50% in common-currency terms. In fact, the relative performance of euro area banks to the euro area broad market has been joined at the hip with the relative performance of euro area equities vs. U.S. equities over the past decade (Chart 1, panel 1). Getting the bank view right in the euro area is therefore an important input into our country allocation decision between U.S. and euro area equities.

Chart 1
Is It Time To Buy Euro Area Banks?
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With a more than 50% discount to the broad market in terms of price-to-book (P/B), banks are now looking very cheap. However, banks in the euro area have always traded at a discount to the broader market on an absolute basis. Currently the relative P/B reading of 0.45 is only slightly lower than the 3-year average of 0.47 – still higher than the lower band of the valuation range (Chart 1, panel 2). The relative dividend yield also gives similar information (Chart 1, panel 3). Historically, when the relative P/B discount hits the lower band and the relative dividend yield hits the upper band, a rebound in relative return performance could be expected.

In order to support sustainable outperformance, however, banks need to have sustained profitability. In this Special Report, we delve into the fundamental factors that affect a bank’s profit outlook such as capital position, loan growth and non-performing loan situation to determine if banks in the euro area are cheap for a reason, or are about to embark on a period of sustainable outperformance.

What Drives Bank Share Performance?

According to research published in BCA’s Global Asset Allocation Special Report on July 27, 2017,1 it is clear that return on equity (ROE) has historically been closely correlated with the performance of bank shares, especially on a relative-to-the-broad-market basis (Chart 2, panel 1).

Chart 2
Euro Area Bank Performance Drivers
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The recovery of ROE has so far been tepid. This is largely a result of deleveraging in the banking system and very low asset utilization, because both return on assets and net profit margins have recovered strongly (Chart 2, panels 2 and 3).

Since the Global Financial Crisis (GFC), euro area banks have steadily reduced leverage to a multi-decade low, while asset utilization has been in a downtrend since the 1990s – even though this ratio seems to have been stabilizing over the past few years.

Profit margins reached a historical high of 12.7% in Q4/2006, then collapsed during the GFC and reached a low of 0.34% in Q3/2009. The subsequent rebound in profit margins was short-circuited by the euro debt crisis, causing net profit margins to plummet into negative territory, reaching a historical low of -7.6% in Q3/2012. They have recovered strongly since, reaching 9.8% in Q3/2018, not far from the 2006 peak margin level. 

As such, banks have to increase their leverage and asset utilization in order to generate higher ROE. This also means they need to increase their asset base and take on more risk. Do banks in the euro area have the ability to do so? 

Capital Adequacy Vs. Deleveraging

The capital adequacy ratio (CAR), the ratio of a bank’s regulatory capital to its risk-weighted assets, measures a bank’s ability to absorb shocks. As shown in Chart 3, banks in all countries have steadily increased this ratio since the GFC. Banks in Ireland, the Netherlands and Finland have the highest CAR values, but they have all come down from their respective peak levels. On the other hand, Spanish, Italian and Portuguese banks have the lowest CAR readings, though they are still improving. French banks stand out because their capital adequacy ratio has been in a steady uptrend with the least volatility.

Chart 3
Improving Capital Position, But...
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Looking at CAR alone, however, could be misleading when trying to gauge a bank’s capital situation. In fact, the generally rising capital adequacy ratio has mainly been achieved through the reduction of risk-weighted assets in all countries except France (Chart 4).

Chart 4
...With Massive Leverage
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French banks’ risk-weighted assets have been more or less stable since 2006, with a small decline into 2015 and a gradual increase since. Belgian banks have also experienced similar asset growth as French banks over the past few years, though that is after massive deleveraging occurred between 2007 and 2014 (Chart 4,
panel 1).

Both Spanish and Italian banks tried to grow assets in 2014 after several years of deleveraging, but the attempt was short-lived as both resumed asset reduction, starting in 2015 (Chart 4, panel 2).

Dutch banks seem to have stabilized their asset base since 2014, while Irish banks, which cut half their asset base between 2010 and 2014, have continued to deleverage, albeit at a much slower pace (Chart 4, panel 3).

The deleveraging process in Portuguese and Finish banks has been ongoing since 2010, and it seems that the painful deleveraging process may have come to a stage of stabilization (Chart 4, panel 4).

In terms of regulatory capital, the numerator of the capital adequacy ratio, French banks again stand out with a steadily increasing regulatory capital base, while Dutch banks have also grown their regulatory capital base at a similar pace. The regulatory capital bases in Spanish, Italian and Belgian banks, however, have been oscillating over the past decade, while Portuguese and Irish banks’ regulatory capitals have declined significantly (Chart 5).

Chart 5
Regulatory Capital Growth: No Synchronization
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Another indicator of bank resilience, the ratio of non-performing-loans (NPLs) net of provision relative to capital, measures if a bank can write off all of its bad loans and remain solvent. How do all the banks measure up in this aspect?

Even though banks in all countries now have good readings (less than 100%), both Italy and Portugal were under severe stress until only a few years ago. Despite significant improvement since, banks in these two countries still have high levels of bad loans relative to capital compared to banks in other countries in the region (Chart 6).

Chart 6
Bad Loans Are Well Provisioned
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Loan Quality Vs. Quantity

The ratio of NPLs-to-gross loans provides potentially useful insights into the quality of assets. 

NPL ratios in France, Germany, Belgium, Austria, and Finland are all less than 5%, while those in Italy, Portugal and Ireland are higher than 10%, and Spain is in between (Chart 7). Since the peak around 2015, the NPL ratios in all countries other than Finland have come down. Compared to levels before 2006, however, bad loan ratios are still high.

Chart 7
NPL Ratio
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In addition, despite the improvement in asset quality, banks have not aggressively grown their loan books. Only banks in France and Finland have been consistently lending to their respective private sectors – along with German banks, albeit at a lesser pace. Lending to the private sector in Spain, Portugal and Ireland has in fact contracted by 40%-50% since 2008, while loan growth from banks in Italy, Austria and the Netherlands has basically been flat since the GFC, as shown in Chart 8.

Chart 8
Bank Loans To Private Sector
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Exposure To Emerging Markets

Banks in the euro area are known to have a strong presence in the emerging markets. As shown in panel 1 of Chart 9, Spanish banks have more than doubled their lending to emerging markets (EM) since 2006; even after a reduction over the past two years, loans to EM still account for over 16% of total lending. This stands in stark contrast to their domestic lending, which has contracted sharply since peaking in early 2009 (Chart 8, panel 3). Portuguese banks share similar patterns to Spanish banks in terms of loan growth to EM and domestically, however, their absolute amounts have been much smaller (Chart 8, panel 3 and Chart 9, panel 2).
Dutch banks shrank their loan books to EM right after the GFC but have been gradually building them back up since 2011, while Austrian banks have been steadily reducing the pace of their lending to EM (Chart 9, panels 3 and 4).

Chart 9
Bank Exposure To EM
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After the turbulence earlier this year in Turkey and Argentina, BCA’s Global Investment Strategy  and Foreign Exchange Strategy services identified six countries (Argentina, Turkey, Colombia, Brazil, Mexico, and Chile) as the most vulnerable to catching the “Turkish Flu,” based on the following factors: current account balance, net international investment position, external debt, external debt-service obligation, external funding requirements, private-sector savings/investment, private-sector debt, government budget balance, government debt, foreign ownership of local-currency bonds, and inflation2 (Table 1).

Table 1
Vulnerability Heat Map For Key EM Markets
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The vulnerability of Latin America highlights the poor performance of Spanish banks, given their heavy exposure to the region. For example, Banco Santander, the largest Spanish bank and also the largest component in the euro area bank index, has aggressively expanded into Latin America to beef up asset utilization and return on assets. However, loan quality from Latin America has been much lower, as evidenced by the much-higher percentage of bad loan provisions from the region compared to its share of loans. Currently, loans to Latin America account for about 18% of total lending, yet bad loan provisions account for about 42% of total provisions (Chart 10).

Chart 10
Banco Santander: More Like An EM Bank
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Exposure To Italian Government Debt

The fiscal budget saga in Italy has been a negative factor impacting euro area assets, especially Italian banks. Italian banks have been large buyers of Italian government debt securities, reaching over 400 billion euros at the peak and accounting for about a quarter of total debt securities. Following the European Central Bank’s quantitative easing program (QE) that started in March 2015, Italian banks’ share of government debt holdings subsequently dropped to about 18% by the end of 2017. In 2018, however, Italian banks purchased more government bonds to a level of 393.8 billion euros as of September 2018, or about 20% of the overall debt securities outstanding – only a tad lower than the peak level before the QE program (Chart 11). 

Chart 11
Italian Debt By Type Of Investor
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Now the ECB’s QE program is expected to come to an end soon. With government debt securities holdings accounting for 24% of tier 1 capital in Italian banks, (Chart 12), investors should pay close attention to the “Doom Loop,” i.e. when weakening government bonds threaten to topple the banks that own those bonds, the banks are forced to unload the bond holdings, which in turn pushes the government into additional fiscal stress.

Chart 12
The Doom Loop
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Moreover, Italian banks are not the only banks in the euro area which are exposed to Italian government debt. According to the European Banking Authority’s 2017 Transparency Exercise, French and Spanish banks held 44 billion euros and 29 billion euros of Italian debt, respectively. For example, the largest French bank, BNP Paribas (BNP), which is the second-largest component by market cap in the euro area bank index, has gradually added more Italian government debt securities since 2015 (when the ECB started buying Italian bonds) following a large reduction in 2011 (Chart 13).

Chart 13
BNP’s Exposure To Italian Sovereign Debt*
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Investment Implications

The euro area banks and diversified financial sector indices are currently mostly dominated by Spain (30%), France (25%) and Italy (15%), which all have grown at the expense of the German banks over the past two decades (Chart 14).

Chart 14
Euro Area Bank Index: High Concentration
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From a fundamental perspective, only French banks have both good-quality assets with decent and steady loan growth; the largest weight – Spanish banks – has experienced negative loan growth domestically while expanding aggressively to emerging markets up until 2017.

Some may argue that exposure to Italian debt and emerging markets may have already been fully priced in, given the massive underperformance of the banks. This may well be true, and there could be a short-term bounce in bank stocks, given the attractive valuation metrics. For long-term investors, however, such a bounce may not be captured easily. We suggest long-term investors stay away from euro area banks, in line with our regional equity view of favoring the U.S. over the euro area. Why? Because cheap valuations are offset by lackluster profit outlook at a time when growth is slowing and monetary policy is becoming less accommodative (Charts 15A and 15B). Relative earnings growth for both banks and diversified financials are closely tied to the euro area PMI, the leading indicator for economic growth (Charts 15A and 15B, panel 2). This growth link explains why the banks’ relative performance in the euro area has such a close correlation with the performance of euro area equities relative to their U.S. peers.

Chart 15A
Poor Profit Outlook For Banks
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Chart 15B
Poor Profit Outlook For Diversified Financials
Chart 15B

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For investors with a more tactical mandate and much nimbler style, however, Chart 1 could be used as a guide to “time” an entry and exit to the industry: go overweight when the relative price-to-book reaches the lower band and relative dividend yield reaches the upper band, and vice versa.

 

Xiaoli Tang, Associate Vice President
xiaoliT@bcaresearch.com

Appendix 1  

Euro Area Bank Indexes

Different index providers have different classifications and compositions for banks, based on their different respective index methodologies.3, 4

GAA uses the MSCI All Country Equity index as its global equity benchmark. As such, whenever possible, we use the MSCI indexes in our research work. When data is not available from MSCI, however, we also use the Datastream Thomson Reuters (Datastream) index.

In this Special Report, we have combined the MSCI “Bank Index” and “Diversified Financials Index” into one Aggregate Bank Index for one reason: MSCI reclassified Deutsche Bank as a “diversified financial” from a “bank” in 2003.

Appendix Table 1 and Appendix Table 2 show the comparisons between the Datastream Bank Index and the MSCI Aggregate Bank Index. Even though Datastream includes 16 countries and MSCI includes only eight countries, both indexes are quite concentrated in Spain, France, Italy and the Netherlands. These four countries account for 77.4% of the Datastream Bank Index with 34 stocks, while they account for 78.8% of the MSCI aggregate bank index with 19 stocks. What’s more, the top five stocks are the same in both indexes, but they account for half of the MSCI Aggregate Bank Index and only 42% of the Datastream Bank Index.

Appendix Chart 1
Euro Area Bank Index Country Weights Comparison
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Appendix Chart 2
Euro Area Bank Index Top 10 Stock Weights Comparison
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Consequently, while the two indexes are quite similar, users should be aware of the differences. For example, since March 2009, the MSCI Aggregate Bank index has underperformed the broader index by 48%, but Datastream banks have underperformed the broad index by 55%, as shown in Appendix Chart 1.

Appendix Chart 1
Bank Index Performance Comparison*
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Footnotes