28th October 2018

🏦 Bank Capital 🆕 (Free Content)

Welcome to the first edition of Bank Capital, GJ Prasad’s new column on CreditMarketDaily.com focusing on bank capital instruments.

It is getting tougher to please..

It has been a tough week for bank stocks globally as reflected in the almost 5%+ drop in XLF in the US and 6% drop in SX7E in Europe and it just did not matter in terms of single names.

We had a number of large-cap European banks (Barclays, DB, Lloyds, UBS, RBS) report Q3 earnings and despite decent earnings from the banks, the sector sold off on macro worries, Brexit uncertainties, Italian politics and potential disruption to business models going forward.

It seems that equity investors are starting to apprehend that banks may no longer be growth stocks but potential value traps.

A Tale of Two Investment Banks

Deutsche Bank stock was down almost 10% on the week as equity investors were not particularly impressed with the revenues trajectory especially in FICC business. Though the bank reported overall net income that was better than expected, the underlying numbers reflected the difficult state of play and the headwinds faced by the bank. ROTE is around 1.7% and the bank is targeting a 4% ROTE by 2019. Tangible net asset value is EUR 25.81 and stock is now trading around EUR 8.5, reflecting deep investor scepticism over its turnaround prospects. The cost to income ratio of 90% is just not sustainable for any bank.

Yes, revenues need to go up dramatically but the investment banking industry (and especially FICC business) is undergoing a huge structural change. Credit investors may be comforted by the healthy CET1 ratio of 14% and the sound liquidity metrics but can they keep ignoring the very poor profitability and the bank’s equity that trades at 0.34 times tangible net asset value (TNAV)?

Barclays, on the other hand, reported decent results especially in the investment bank and with a standout performance in the equities unit. Markets income is up by 19% and within that FICC up 10%. YTD ROTE at 11% (double-digit for a European bank!!!) reflects ongoing transformation (especially retreat from underperforming international retail businesses) and revenue growth in markets business.

Overall CET1 at 13.2% is decent and the organic capital generation certainly provides plenty of cushion for any Brexit uncertainty. The bank’s stock is trading at a steep discount to reported TNAV and it seems that that bulk of this discount is coming from investor pessimism on the future profitability of the investment bank.

It’s All About Brexit From Here

Lloyds Banking Group and RBS reported earnings that reflected the underlying strength of the UK retail and commercial banking industry. Lloyds continues to report solid earnings, asset quality and capital metrics.

RBS has come a long way in its turnaround story and reported very strong pre-tax operating profits with very low loan loss provisions. RBS CET1 ratio of 16.7% gives the bank plenty of options in capital management and with solid buffers well placed to handle any unexpected turbulence.

Finally, UBS also reported numbers that were better than expected and its reliance on wealth management and private banking coming to the fore. This once again demonstrates the value of identifying key strengths ahead of time and then reinforcing the advantage.

What does it mean for credit?

From a credit investor perspective, in my personal view, Lloyds and UBS are clear defensive names to own in the higher parts of the capital structure in a broad risk sell-off. RBS is now starting to become a sound credit story given its capital and liquidity metrics but the hangover of past restructuring is still there.

Barclays is an interesting example wherein equity seems to look more attractive than the bank’s AT1 purely from an upside/downside perspective. DB is clearly a case of credit investors hoping that the bank’s restructuring pays off and profitability (and more importantly revenues) improves and to that extent driven by overall market perception.

GJ Prasad

A senior European bank research specialist with significant breadth/in-depth sector knowledge, GJ has researched bank capital instruments extensively - having covered the asset class for more than 15 years as an analyst and 7 years as a risk taker in buy-side roles. His specialisation includes carrying out detailed financial modelling work on the European banks focusing on asset quality, earnings and capital adequacy metrics. His deep-dive work focuses on single name selection and extensive risk analysis on capital securities, especially on structural features, issuer credit profile and equity/AT1 valuation.