4th March 2019

European Banks: Never a Dull Moment | Bank Capital Insights

They come in threes…

First, it was Danske. Then came Swedbank, followed by Nordea. Suddenly, the money laundering scandal issue is starting to look systemic in the Scandinavian banking system. All three banks are very well capitalised and hence in a good position to absorb any large settlement/remedial costs.

But the impact on earnings is likely to be substantial and the uncertainty means modelling any earnings estimates likely to be very difficult.

Add to this the pressure on interest margins (given the accommodative monetary policy in Europe) and ongoing disintermediation by new FinTech players, the ability of the banks to generate decent ROE is questionable.

AT1s issued by Scandinavian banks trade very tight on spread basis given their flight to quality status in the past and high reported regulatory capital ratios.   The risk premium demanded by investors to hold the AT1s issued by the Scandinavian banks seems low and I would expect re-pricing.

When One Plus One Equals Half

The FT reports again that the German government is actively pushing for a merger between Deutsche Bank and Commerzbank and if it does happen it would be the worst kept secret.  At first glance, this looks an interesting option to combine two underperforming banks with similar attributes in terms of low profitability and limited future visibility but with significant scope for cost reductions and a larger capital pool to absorb losses.

However, merely creating a much larger entity does not solve the underlying core issues faced by both banks, more so for DB.  The reason being that the bank is too large and too complex to be managed as a standalone entity and any additional merger will only complicate matters and cause further uncertainty.   Personally, I think the merger will make things worse for both banks and will result in more shareholder value being destroyed.

DB’s issues stem from multiple factors – Oversized/overstaffed businesses in FICC land and a strategic failure in the past to redirect capital to the more profitable wealth management and corporate banking businesses.  FICC is a highly cyclical business and one that is undergoing profound structural change.  Technology and automation are the key drivers of profitability in that business and DB has been very slow to react and adapt to the new landscape.

What DB needs is a radical restructuring in the FICC business and it needs to get rid of many units that are currently generating very poor returns.  That, and downsize its balance sheet exposures significantly.

Equity investors have taken notice of the issues and hence give the poor valuation on its stock. It seems that credit investors (especially AT1 and LT2 investors) are stuck in no man’s land, unsure of what to do next (yes, the yields are attractive but there are significant tail risks).

Sun shines in winter for the Italian banks

Italian bank stocks and AT1s have rallied significantly in the last couple of months and almost rallied the losses seen in Dec 18 driven by three things – subsiding tail risks from Italian politics (as seen in tightening of BTP/Bund spreads, better than feared capital requirements from the SREP process and expectations of another fixed term TLTRO from the ECB.

The banks themselves have increased the Italian government holdings and reaped the benefits of the subsequent rally (but increased the sovereign/bank nexus even more).

Credit investors seem to have gorged on Italian bank bonds in the last few weeks, leading to a significant tightening of spreads and inflicting pain on shorts. All this in the face of poor economic numbers and potential recession this year.  It goes on to show how central banks can effectively reduce price volatility by providing extensive liquidity and giving banks time to rehabilitate and pretend/extend the day of reckoning.

Amongst the Italian banks, Unicredit seems to be the one that has most upside as it has been ahead of the curve in terms of balance sheet restructuring and is well diversified with its businesses in CEE / Germany and Turkey.  Having said that, it is the most volatile name to own given its exposures in Italy and Turkey.

Intesa seems more defensive but it still has to do a bit more restructuring of its legacy NPLs and as the largest Italian bank, it is never far away from an Italy-related headline.

The most interesting name in Italy for credit investors is MONTE and it is enough to say that this bank is for the brave-hearted and we shall cover that name separately.

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.