7th March 2019

When the DOVE turned even more DOVISH | Bank Capital Insights

Carry on “TLTRO”…

In a slightly unexpected move, the ECB pushed out the timing of its first hike until the beginning of 2020 at the earliest and offered banks a new round of TLTRO loans to help revive the euro zone economy.  In the process, the ECB further lowered the growth and inflation forecasts for 2019 and 2020.  It certainly seems that the ECB is unlikely to be able to hike interest rates any time soon.  Nor will it be able to stop providing cheap loans to the EZ banking system.

The new TLTRO program will be available from Sept 2019 and run until March 2021 and will make it easier for banks to roll over the debt maturities in that period removing a significant tail risk for the banks.

Further, it is hoped that financing conditions will continue to ease and credit growth to continue.  But this also means that banks earnings will remain lacklustre as margins will be impacted even more.  And if the economic slowdown turns into a recession, loan losses are likely to increase.  Who wants to own European bank equities given this outlook?

Carry is king again

The latest measures will obviously help bank debt spreads to tighten further and may force investors to own more riskier instruments in the hunt for carry.  To that extent, the Non-Preferred Senior and AT1s issued by peripheral banks are likely to benefit the most.

One of the key takeaways from this announcement is that the ECB is in a way worried about the rollover of existing bank debt especially those issued by the weaker periphery banks and that the banks may not have easy access to capital markets.

This subtle message has implications for the risk premium needed for capital instruments and I believe that the markets will price in higher risk premium for the LT2s and AT1s issued by banks perceived to be weak.  It is entirely possible given the drop in swap rates, some banks just do not call their AT1/LT2s as cost of new issue may be higher than the cost of non-call.

Single name selection still key

If bank equities sell off significantly from current levels, this will impact investor sentiment especially in AT1.  Whilst the ECB may have helped the weaker (and smaller banks) in giving them cheap funding, they have inadvertently caused earnings issues for the whole EZ banking system.

This means careful single name selection is needed and despite the potential TLTRO 3 driven carry mania, some names will not perform and the trick is to avoid these names.

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.