17th February 2019

Let it Rip | Bank Capital Insights

Risk-on week for EU banks

Last week was a good one for European banks with risk rallying across the board – from equities to sub debt to single name CDS to credit indices.  We had a number of banks reporting earnings and investors liked what they heard – especially from the banks that have almost completed their restructuring – Commerzbank, Credit Suisse and Royal Bank of Scotland.

The one common theme across the earnings reports was that market activities continue to be a struggle for everyone to make money and normal commercial banking with tight cost controls and low credit costs provide decent returns.

Adding to the positive sentiment, ECB board members seemed to indicate that another round of TLTRO would be made available to the banks, which of course would aid in eliminating potential liquidity concerns especially for the banks in the periphery.

Credit seems to be a nice place to hide for now

The earnings picture from the banks that have reported so far indicate that the health of the banks is definitely in much better shape than perceived. Asset quality metrics look solid and that is a function of the benign credit conditions in Europe.  Capital ratios are ticking up with CET1 ratios moving towards the teens (there are some surprises though) but leverage ratio is still a work-in-progress for the larger banks with bigger investment banking units. But, if any of the tail risk events were to materialise, earnings momentum is at risk for most of them and hence equity investor apathy.

Sub debt is always going to trade on the back of equity performance and investor perception and hence unlikely to materially tighten in spread terms but may outperform equity. It appears to me that LT2/Non-preferred senior bonds issued by the larger banks are attractive as defensive plays to fund shorts in other parts of the capital structure and/or across names.

AT1 – nice roller coaster week

Last Tuesday, we had SANTAN announce their non-call decision on the EUR AT1s. Initially, there was a negative reaction but from next day onwards AT1 markets shrugged off SANTAN’s non-call decision (in fact the bonds traded up) as investors now believe that the bank may yet call this issue within the next 12 months (bonds can be called every 3 months from now on).  The non-call decision has not impacted the overall markets and maybe it reflects investors maturity (only time will tell).

Svenska Handelsbanken issued a USD Perp NC 5 AT1 with a yield of 6.25% and there was very good demand for the issue.  As one of the strongest Nordic banks with strong capital and liquidity metrics and (more importantly) investment grade ratings at the issue level meant that the 6.25% yield on the bond was too good for investors to pass up.

RBS AT1 in USD look attractive

RBS reported FY 2018 earnings last Friday morning reflecting significant progress in balance sheet clean-up and solid improvement in both capital and liquidity metrics. With a CET1 ratio of 16.2%, MDA headroom of 6.4% and NO AT1 issuance this year, both the USD AT1s look attractive to own.

Also on the liquidity side, the bank is reporting a loan-to-deposit ratio of 85% and LCR of 158% – these are strong numbers. The real issue is improving profitability as RoTE is still a low 4.8%.  And of course, there is Brexit induced uncertainty. Both of which I believe are issues for equity investors.

Having said that, RBS is set to return significant capital back to investors given the internal capital generation and excess capital. All in all, it seems that years and years of restructuring is finally starting to pay dividends and the AT1s do look good.

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.