In contrast to past financial crises, in 2020, banks are not considered the cause. Instead, decision-makers have promptly provided massive support to ensure that banks are part of the solution. Fiscal stimulus has been granted by central governments to individuals and companies through the banking systems, in the form of moratoria, loan guarantees, direct liquidity support and increased pressure towards greater SME’s lending.
In order to strengthen and amplify the role of the banks in this crisis, the European Central Bank (ECB) has been very supportive, deciding to temporarily allow for:
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Capital relief: above EUR 120 billion of capital release to absorb losses (about USD 500 billion globally), thanks to the temporary use of capital and liquidity buffers, implementation of art 104.a (allowing banks to use AT1 and Tier2 bonds to build capital buffers), asking banks not to pay dividends and share buybacks (around EUR 30 billion capital savings).
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Liquidity support: easing TLTRO 3 conditions to support SME’s lending, benefiting net interest margin (up to -1% interest applied). As of September 2020, the total ECB funding usage hit the new record of EUR 1.75 trillion (compared to a EUR 1.26 trillion usage during 2011/2012 sovereign crisis).
The banking sector is highly sensitive to the economic and geopolitical tensions. While asset quality of loans seems to be under control for now, COVID-19 has severely impacted the macroeconomic environment, implying a deterioration of asset quality in the next quarters. Meanwhile, long lasting lower interest rates will impact revenue generation. The cost of risk reached around 88bps in 1H2020 (almost 4.4 times compared to the same period last year at 20bps) and market consensus expects cost of risk to peak above 100bps on average for EU banks by the end of 2020. However, even if provisions have been increasing, balance sheet numbers do not provide enough clarity about the inflow of new NPLs, mainly due to fiscal support to economies and banks’ forbearance measures. Stage 3 loans (non-performing loans) are almost stable while stage 2 loans (loans with significant increase in credit risk since recognition) increased moderately, creating doubts on the strength of the banking sector; some banks’ asset quality may prove to be much weaker than expected in the next quarters. On average European banks have a 15-20% loan exposure towards the sectors that have been most impacted by COVID 19. Transparency and sensitivity analysis on both banks’ balance sheet and performance is crucial to address investor concerns about banks’ business sustainability.
In some European regions, where the growth pace of NPLs is generally higher, risks cannot be underestimated. Recently, the Italian banking association (“Associazione Bancaria Italiana”) highlighted that the average level on NPLs in Italy is still above the 5% target given by the European Banking Authority notwithstanding the EUR 130 billion reduction reached in the period between 2015-2020. The positive trend is under high risk of reverse, jeopardizing the efforts made so far. On a positive note, the creation of a European bad bank is gaining momentum, and the NPLs market is still alive despite the pandemic: Unicredit is selling EUR 1.5 billion of NPLs while BPER is completing a EUR 1.2 billion securitization.
Since the beginning of the COVID-19 crisis, negative rating actions on banks have been quite intense compared to the corporate sector, with significant migration towards BBB+/BBB ratings and downgrade outlooks to negative. In some cases, this has also been exacerbated by sovereign risk as seen, among others, with Italy, Belgium, France and UK.
In these fragile circumstances, European banks are clearly destroying value with Return of Equity (ROE) lower than Cost of Equity. Cost cutting and M&A are the two options available in this low interest rate and shrinking economic environment (EU GDP -21.1% in 2Q20). Thanks to a favorable ECB approach (no capital add-on and use of badwill, the condition that arises when the price paid for identifiable assets is lower than their net fair market value) domestic and cross-border consolidation is picking up pace.
The profitability gap with US banks is clearly growing and despite setting aside around USD 35 billion for potential bad loans, the six biggest Wall Street banks still made almost USD 13 billion in profit during the second quarter. Cross-border consolidation is therefore the main driver to create European champions able to compete internationally. In the past weeks, several headlines hit the news in relation to possible M&A activities of European champions: the CEO of Deutsche Bank considers M&A to be an option for next year; UBS is a possible candidate for national and cross border M&A; BBVA is interested in Sabadell and Credit Agricole is likely to expand its Italian business. Commerzbank is also a strong candidate for consolidation. However, the non-completion of the European deposit insurance scheme (EDIS), also referred to as the third pillar of the European banking union, is still the main obstacle.
In Italy, Spain and Germany the banking sector is still too fragmented, while this would be the right moment to solve inefficiencies in domestic banking sectors. In Italy and Spain, the medium/small size banks are weak, have low profitability, a relatively high cost base and significant level of NPLs. Moreover, expensive as well as limited market access jeopardizes their ability to issue bail-inable bonds, with the risk that the taxpayer will once again be called to bear the losses of failing or likely to fail banks. In my opinion, consolidation is also a way to have resolvable banks in Europe, in order to create stronger institutions, able to attract the interest of institutional investors and have higher own funds and liabilities buffers.
In that respect, the consolidation of Intesa and UBI in Italy and Caixa and Bankia in Spain can be seen as a trigger for more M&A activity in Europe.
Bonds issued by the banking sector amount to around 27% of the Iboxx Euro corporate investments grade index, making it the largest sector. Exposure to banks is thus inevitable for fixed income investors. After a massive widening in March-April 2020, banks’ spreads rapidly recovered, mainly due to ECB support and national government fiscal measures. In September 2020, the portion of negative yield bonds in the investment grade universe was 22% in financials vs 20% corporates, while in December 2019 it was 13% vs 14% respectively. At the current bonds spread, both Senior and Subordinated bonds (Tier2) issued by the banks are rich in my opinion. Subordinated bonds appear to be expensive compared to corporate hybrids with a 1.16% Yield against 2.33% (2.35% and 3.17% in April 2020). Moreover, supply is above last year’s level, EUR 25.1 billion versus EUR 19.2 billion, following the implementation of art 104.a.
Banks Additional Tier 1 perpetual bonds (AT1) have a better relative value compared to Tier2 and high yield BB bonds. Yet, AT1 benefit from temporary support provided by regulators coupon preference over dividends and the 104.a implementation, which allows banks to issue more AT1 to increase capital, leading to a lower coupon and non-call risk. However, AT1 are more complex products and specialized investors only should be active in this segment.
I expect bank bonds spreads to be under pressure in the coming months, due to the second wave of COVID- 19, the overall economic outlook and the US presidential election results. The level of NPLs will also depend on the extension of fiscal support programs and debt payment moratoria. Bloomberg consensus expects earnings to fall by -48% in 2020 and rebound by around +58% in 2021. Nonetheless, common equity tier 1 (CET1) buffer compared to requirements (%RWA) is for most of the banks above 3%, including the Italian national champions (Unicredit is around 4% and Intesa is well above 4.5%).
As such, it is better to prefer the safest part of the capital structure (Senior bonds, although the portion of negative yield bonds is significant) and banks with better profitability and lower levels of NPLs. Nordics banks and retail core Europe (mainly French, Benelux and Swiss banks) are preferred choices, while the UK and peripheral banks the least, given the current valuation. The latter performed quite well on the back of consolidations and better sovereign bonds performances. Thus, the likelihood of a new catalyst is limited in the second half of 2020.
On the other side of the ocean, US Banks already anticipated lower provisions in 3Q2020 and still strong capital market revenues from trading. Although manageable, I would expect signs of higher delinquencies in the consumers and commercial real estate loans books, given the good profitability of the Wall Street banks. Again, a positive element for bondholders is the FED announcing that the biggest US Banks will face restrictions on dividends and share buybacks for another three months, citing the need to conserve capital.
Capital conservation is and will be a key focus for bondholders as well. An average ROE of around 5-6% is not only low to attract equity investors but also to generate internal capital to protect bondholders. Moreover, a cost of risk above 150-200bps for a prolonged time period will create significant losses for the sector, given the low rates environment. The banking sector is once again facing really difficult times.
