4th February 2019

Perceptions can sometimes be wrong | Bank Capital Insights

Italian banks may be the focus but the French banks may need a re-assessment

Without a doubt an Italian recession or political crisis will have significant impact on the Italian banks given the amount of government debt they hold and the ongoing reliance on ECB for funding.  And these issues are well documented and no real surprise and hence no point in pretending otherwise.

There was this Bloomberg article today outlining the exposure numbers and why everyone is scared of Italy.

However, it seems that credit market (especially subordinated debt) investors seem to perceive that the French banks are in a much better position….

I would argue that perception is misplaced to some extent and that they carry significantly higher tail risks in the balance sheets.

All the three major French banks (BNP, SOCGEN and Credit Agricole) have significant issues to contend with – slowing domestic and Eurozone growth, significant cross border exposure especially to periphery and EM, subscale investment banking business with high operating costs and more importantly, running leveraged balance sheets.

BNP is not what you think

BNP has the best perception of having strong fundamentals but the reality is slightly different.  Of three banks, it seems to me that perception issue is most significant at BNP and it seems to get the benefit of the doubt (in terms of credit spreads) given its status as French national champion bank.

To start with, the bank like its peers is struggling to generate decent revenue growth in its corporate and investment bank, especially in its FICC business.   On top of that, the bank’s cost-to-income ratio is in the 70% area.   Loan losses have come down but that is due to benign economic conditions in Europe. Yes, it reports an acceptable 9% to 10% ROE for now but earnings are now exposed to multiple headwinds.

Asset quality and risk management used to be the bank used to be strong points but with a large stock of NPLs and presence in Italy, Turkey and other Emerging Markets and exposure in personal financial services, future credit-related costs may yet go up. And additional provisioning may be needed at a time of decreased revenues and stagnant cost base.

Overall funding metrics seem fine with a loan-to-deposit ratio around 94% and a highly diversified funding base. But that cannot mask the bank’s reliance on short term funding given its large balance sheet size. As a large and frequent issuer of debt securities, the bank has very good access to capital markets and is able to issue debt at satisfactory spread levels.

Capital is where I find that the bank has really not kept pace with global peers. Yes, CET1 ratio is a decent 11.7% and leverage ratio at 4% (and it was at 4.6% at end of 2017) but in the event of a large tail risk event, these ratios drop sharply. In the recently concluded EBA stress test, the bank’s CET1 ratio dropped to 8.64% in a hypothetical adverse scenario.  The bank seems to have levered up its balance sheet in recent periods especially in the investment bank.

Are credit investors just ignoring the risks?

Given the leverage situation and potential for headline risks stemming from presence in Italy and Mediterranean countries, in my view, BNP’s AT1 securities and LT2 debt seem to trade tight. I think that this is a function of the bank’s French domicile and perceived strong risk management strengths.

Relative to equity, I wonder if AT1 holders are more comfortable with current levels despite the recent underlying trends and issues and if they are relying on past track record.  Only time will tell if this comfort factor of credit investors holds.

To conclude, I would rather underweight the sub debt issued by the French banks ahead of their Q4 earnings as it would give investors a significant cushion from multiple tail risk events.

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.