European banks: Resilient and well-positioned to deal with potential challenges
European banks have come a long way since the global financial crisis. We have seen significant deleveraging and capital build, as well as increased absolute and structural liquidity. Business models have been restructured, with a greater focus on stable core operations and disposals of riskier non-core and less-profitable businesses. This was all driven by much stricter regulation and regular stress testing.
More recently, the sector has weathered a number of crises, including the global pandemic, the fallout from the Russia/Ukraine war, and the US mini banking crisis. European banks also proved resilient in what was the harshest European Banking Authority (EBA) stress test to date in 2023. European regulators have rightfully taken some credit for the improved resilience in the EU banks sector, and we take some comfort from the strength of supervisory scrutiny in Europe. This is set to continue, with a focus on credit, data and risk aggregation as well as digital, governance and ESG risks.
Balance sheets are in robust shape
As the charts below show, asset quality and capital positions are historically strong, and liquidity sound. Non-performing loan (NPL) ratios in the eurozone have reduced consistently in recent years (Chart 1), largely driven by material improvement in the periphery.
The average CET1 ratio for our coverage universe improved by 30 basis points (bps) year on year (y/y) in 2023, and the average buffer to regulatory requirements remains solid at 420 bps (Chart 2). Importantly, capital remains strong despite material shareholder return in 2023 (Chart 3). Basel 4 remains a regulatory capital overhang, phasing in from January 2025, but European banks have already significantly frontloaded and mitigated impacts here in recent years, and we now consider them manageable.
Shareholder returns for European banks have risen significantly, with dividend payout ratios of 50-80% and sizeable share buyback activity. Distributions are expected to remain high in 2024 and banks should gradually get closer to their CET1 target ranges, resulting in a decline in buffers to minimum requirements (MDA). However, capital generation is expected to remain healthy, and regulators have also imposed substantial countercyclical buffers (CCyB), which can be released in a downturn and create additional capital headroom (see Chart 3). From a credit perspective, banks’ increased capital flexibility is positive, but we would expect more caution (also from regulators) if macro data or asset quality deteriorates significantly.
Importantly, profitability, which had long been the weak spot for European banks, has improved markedly in recent years, supported by the rise in interest rates. The latter led to net interest margin (NIM) expansion as the asset side of the balance sheet has repriced faster than liabilities; as a result returns on equity (ROEs) have improved to low/mid-teens currently, comfortably meeting most estimates of banks’ cost of equity. At the same time, the sector has maintained robust liquidity and funding positions, and European banks have not seen material deposit outflows.
NIMs mostly peaked at the end of 2023, and FY24 outlooks reflect forward rate assumptions, further gradual increase in deposit betas, and migration to fixed term deposits, hedging strategies and mix effects, as well muted loan growth. Banks also highlight that sensitivities to rate moves have reduced, while some banks have sizeable fee/commission income, making them less sensitive to lower net interest income (NII). In 2023, loan growth was very muted, with banks cautiously constructive here for 2H24, and this will be an important driver for profitability growth going forward. In general, we expect to see a moderate earnings decline from current high levels, but earnings and returns on tangible equity (ROTEs) are expected to remain healthy and at much higher levels than in 2021 as the absolute level of rates remains supportive. The latter is a game changer for EU banks vs. the previous zero/negative rates environment.
Importantly, despite lower NII, pre-provision operating profit (PPOP) loss absorption capacity (which increased >80% since YE20 vs. YE24 expectations) is anticipated to remain comfortable even in a downside scenario of higher provisions and lower earnings. We note that the current outlook is for a gradual normalisation of loan loss provisions in 2024 rather than any spike higher. However, as the red bars in Chart 6 show, the cost of risk would have to jump significantly and exceed the levels seen in recent stress tests to wipe out PPOP (i.e., cause banks to report a net loss in a given year).
Could we see more M&A in the European banking sector?
As noted, banks have preferred to deploy excess capital via share buybacks, with M&A activity remaining confined to smaller bolt-on type transactions. More recently, there have been some in-market M&A deals (especially in the UK and also some chatter in Spain), and the incentive to boost cost efficiencies may result in further such transactions in 2024. However, we do not expect larger cross border deals in the near term, as the impediments here remain in place—in particular, the lack of a common deposit guarantee scheme. Ultimately, we think cross-market M&A will be important for European banks’ competitiveness.
What risks are we watching and where do we go from here?
The macro environment has been resilient and unemployment levels low, and this has supported a remarkably benign asset quality backdrop so far, despite the higher rates environment. According to our latest GFICC quarterly investment outlook, the risk of recession is currently low. However, we are watching macro risks closely.
- Asset quality is expected to deteriorate moderately from here, as the effects of the period of higher inflation and interest rates have yet to feed through fully to banks’ loan books. In particular, we expect this to play out via some weakness in commercial real estate (CRE) exposure, as well as potentially in the SME and unsecured lending space. However, overall we consider CRE is manageable for our universe. This view reflects prudent underwriting and the moderate size of these exposures, with CRE loans accounting for around 7% of total loans on average for our coverage universe, office exposures (where disclosed) at around 25% of total, and US CRE exposures minimal. A few German specialist CRE banks are heavily exposed, and so we see some idiosyncratic risks, but we do not consider this a systemic risk, given the relatively small size of these specialist lenders and their materially higher exposures. We expect single name defaults and/or lumpier provisions to create some bank specific volatility, though we note that many banks also prudently hold substantial provision overlays. Excluding the specialist lenders, we see CRE as an earnings problem for European banks and part of the expected credit cost normalisation.
- We expect geopolitical risks to remain front of mind for markets, while persistent inflation or a hard economic landing would likely put more pressure on banks asset quality. The Middle East crisis and the risk of higher oil/commodity prices are in focus currently. While the direct exposure of European banks to the crisis areas is very limited, a resurgence of inflationary pressures would increase asset quality risks for banks. Election risks in 2H will also likely bring volatility. Funding conditions remain supportive currently, but money is tighter and market confidence can be fragile. We expect funding and sound liquidity to remain a key focus for banks and have already seen significant frontloading of supply this year, while liquidity positions remain robust.
Investment implications
Bank bond valuations have moved significantly tighter in recent months and are now generally at the lower end of historical ranges, making them less attractive and leaving less room for error. At the same time, yields are historically attractive, 1Q24 earnings so far confirm our views and the European banking sector’s very solid fundamentals, and bank spreads are also still attractive relative to corporate sectors, despite the basis having compressed. Against this backdrop, we remain focused on issuer and capital structure selection, but still like subordinated debt of fundamentally sound or improving issuers (with still some potential ratings upside for a few banks). Technicals here remain supportive, with closer to net zero issuance, and while there has been compression in sub/senior, the differentials are still off the tights here and there is still good carry in names/structures we like.