Instead a war, an energy crisis, recession and runaway inflation conspired to undermine the long-anticipated benefits from the first meaningful interest rate rises in a decade.
Instead a war, an energy crisis, recession and runaway inflation conspired to undermine the long-anticipated benefits from the first meaningful interest rate rises in a decade.
As a result, and despite bumper profits across the region, investors have stayed away as pessimism about rising defaults and potential windfall taxes outweighed optimism from higher dividends and buybacks.
“There is still fundamental nervousness about the sector,” said Magdalena Stoklosa, an analyst at Morgan Stanley. “There’s little faith that banks can rewire, despite the fact that balance sheets are solid, liquid, and very well capitalised, and profitability has improved.”
Morgan Stanley estimated that European lenders’ pre-provision profit will rise 16 per cent in 2022 and another 8 per cent next year. They are forecast to return at least €100bn via dividends and stock buybacks from now until the end of next year, with another €31bn of excess capital to return more or absorb recessionary loan losses.
Long awaited central bank rate rises have juiced earnings through dramatic increases in net interest income (NII), as the amount charged for loans has risen faster than the rate paid out on deposits.
However, that windfall has caused little change in long-term sentiment.
The benchmark index of European banks has fallen 5.8 per cent this year and the comparable UK index rose only 4.5 per cent — both outperformed the broader stock market but on a five-year basis they remain down close to 30 per cent.
Stress testing the system
As was true back in 2018 — seen as a post-crisis nadir for the sector — only two of the 20 largest British, French, German, Italian, Spanish, Scandinavian and Swiss banks trade above book value: wealth manager UBS and Sweden’s Nordea.
But some suggest that the extraordinarily turbulent environment of the past three years should be seen as a stress test rather than a cause for alarm.
“If you had told people we are going to get a war in Ukraine, recession, the LDI pensions blow up and late-cycle episodes like the collapse of FTX and European banks would still outperform the market, that is pretty resilient performance after what was thrown at them,” said Stuart Graham, co-founder of Autonomous Research.
“2022 has taught us that we need to be humble,” he added. “It is a ‘show me’ story to prove banks are cheap. Many investors want to see it before they believe.”
Bank executives from Barclays to UBS have been on charm offensives in the US to sell that story, promising higher payouts and strict cost controls. UniCredit’s Andrea Orcel has committed to return €16bn of capital to shareholders by 2024 as he seeks to boost the share price and win himself a pay rise.
But the legacy of underperformance since the 2008 crisis has been hard to shake. In May, Capital Group — one of the few active investors backing European banks — dumped €7bn of stock after concluding the damage of a recession would outweigh the benefit of rate rises.
“In the last 13 years there has been focus on remediation, restructuring and implementation of regulation. Capital and investment have gone to those rather than innovating and driving growth . . . [this] has left an enduring discount on banks,” said Lloyds chief executive Charlie Nunn.
“People look at us as a bellwether for the UK economy . . . If confidence is rebuilt we will automatically deliver a much stronger share price than we see today,” he added. “But there is a nervousness in investors about how financial services will be able to respond.”
Dark clouds
Those who view 2023 with scepticism point to a likely surge in loan-loss provisions as Britain and the continent head into a cost of living crisis, combined with surging inflation pressuring their cost bases. Additionally, recent signs that global inflation has peaked could mean the pace of rate rises slows.
While in 2021 earnings were given a boost as banks cancelled tens of billions of worst-case coronavirus-related loan provisions, the trend reversed this year. Banco Santander alone has added €7.5bn to its loan-loss reserves so far in 2022, an increase of a quarter from the same period a year earlier.
In the UK, HSBC added $1.07bn to its impairment reserves in the third quarter and chief executive Noel Quinn told the Financial Times this month he had identified $1.7bn of extra cost cuts in order to remain on track to hit its target of expenses rising 2 per cent next year.
“2023 carries higher risk of disappointment versus expectations, especially in a scenario of a worse than expected slowdown,” said Kian Abouhossein, head of European banks research at JPMorgan. A recession “could lead to a double-whammy of fewer rate hikes and asset-quality deterioration”.
JPMorgan is forecasting €63bn of loan provisions in its base case, rising to €118bn in a “stress scenario”. Abouhossein also noted the “curve ball risk” of windfall taxes being imposed by cash-strapped governments, following Spain’s decision to raise €3bn from the interest-rate driven profits of its lenders.
Dividend bans by regulators during the coronavirus pandemic also remain fresh in investor memories, with some concerned central banks will impose fresh restrictions if the economic outlook darkens.
“Capital returns are key, the problem is that they are not decided by loan-loss models or executives, but the view of the supervisor,” said Jérôme Legras, head of research at investment company Axiom. The ECB “will keep a very conservative approach. From a supervisory view there is no downside in being too cautious.”
The tide has turned
But, years of disappointment have not killed all hope.
David Herro, deputy chair of the $99bn asset manager Harris Associates, has been a longtime owner of top-10 stakes in European banks including Lloyds, Credit Suisse and BNP Paribas.
“The European financial sector is one of the most attractive areas to invest given it is now fully or even overcapitalised, the positive impact of higher rates, and the ability to continue to grow lending volumes and fee income,” said Herro. “These should more than make up for the possibility of higher credit costs.”
Fears about 1970s-style stagflation have also not yet come to pass. Unemployment remains low, there is little evidence of customer distress and much of the tens of billions in coronavirus-related bad debt reserves remain in reserve ready to absorb losses.
The trading arms of investment banks such as Barclays, Deutsche Bank and BNP Paribas have seen revenue leap to historic levels as rate rises and geopolitics caused market volatility, which will continue through next year.
“For the last 15 years banks have struggled against a number of headwinds related to strengthening their balance sheets and righting the wrongs of the past, but now the tide has turned,” said Rob James, a fund manager at Premier Miton. “While many sectors will find rising interest rates a struggle, banking, for once, is in the sweet spot.”
