4th November 2018

🏦 Tail risks still wagging the European banks | Bank Capital

Single name dispersion the name of the game

It was a pleasantly risk-on sentiment for European bank stocks last week with the sector (SX7E) almost up 3% for the week.  Yet the sector saw huge volatility in price action right through as headline risks kept investors on their toes.  Also, we had very decent dispersion in price action within the sector with the likes of ING and Standard Chartered up more than 7-8% for the week on better than expected earnings and DB up almost 9% on news of an activist fund taking a 3% stake.

Overall it has been a very good week from a long/short trade perspective if the right single names were paired up. It appears that credit investors were just bystanders in this volatile market set up. Brexit, Italian politics, trade war spill-overs, Fed/ECB policy normalisation and EM turmoil are amongst the many key tail risk events having an outsized impact on future growth and revenue prospects.

Earnings still the key driver

We had a number of large cap banks report last week (HSBC, BNP, BBVA, Santander, ING, Standard Chartered and Credit Suisse). The common theme for positive stock price momentum being – generating positive jaws in operating performance.  Plus, it seems that investors prefer a business strategy that is simple to understand in terms of region or product mix and that seems to be the way forward to generate better shareholder value.  Barring a few exceptions (they are busy restructuring their operating units), overall ROTE is nudging up to 10% at a sector level. It is a pity that COE is just going up as well, as the risk premium for the sector has increased.

Stress results don’t show much stress

We had the EBA publishing the stress test results for the major European banks on Friday and, barring a few negative surprises, this turned out to be a non-event. It remains to be seen if investors think that these tests were credible enough and whether it did capture all the tail risks and the real impact on bank solvency – and more importantly, liquidity. I still think many of the European banks have significant leverage (and this is reflected in the sharp fall in leverage ratios in stress scenarios) and the significant sovereign/bank nexus means the banks are not well capitalised from an unexpected macro shock in EZ land.

Plus, we have the perennial problem of low profitability and overbanked banking systems. In addition, reliance on wholesale markets (I include ECB funding in that) is still an issue and if funding markets were to shut down, we will go back to square one. To that extent, I don’t see these stress test results changing investor perception in a material way.

Long-dated USD AT1 not that attractive to me

iShares 20+ Year Treasury Bond ETF (TLT) traded at a 52 week low on Friday at $111.90 intra-day and is down almost 11% YTD. With the long bond 30 year UST yield trading at a 4 year high of 3.46%, I believe that risk is still misplaced in many parts of the fixed income market. Despite long-dated USD AT1s having significant duration risks (in addition to other trigger related risks and tail risks) I am not sure if investors are getting paid enough to own some of the potentially “perpetual” issues with low coupons/low reset on non-call.

And remember, AT1 instruments generally trade on a cash basis in secondary markets and hence the notion of hedging interest rate risks almost non-existent for many investors. Also, most dealers don’t trade this on spread) and hence hedging the same has its own problems. To hedge or not to hedge is not the question – but what to do next with this instrument here?

Is bank debt a defensive play 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 Non-preferred senior bonds issued by the larger banks are starting to become attractive as defensive plays to fund shorts in other parts of the capital structure and/or across names.

To summarise, bank capital investing is much more interesting from a relative value perspective and to some extent this strategy takes out the directional risk element.

It may be safer to play that way until the clouds disappear.

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.