European banks to ride yield curve higher

LONDON: Improving economic conditions, a steeper government bond yield curve and an overall decline in bad debts suggest 2017 is shaping up as the healthiest year for Europe´s banks in almost a decade.

The brighter outlook for the sector has in recent weeks prompted the first upgrades to analysts´ earnings forecasts since 2010 while banking stocks, underperformers for three straight years, have raced to their highest levels since last January.

This marks a sharp contrast to a year ago when concerns about weak economic growth, the impact of negative interest rates on bank profits and higher regulatory costs provoked sharp falls in banking stocks across the region.

The steeper curve, which shows a rise in long-dated bond yields, is a boon for banks as they make money by borrowing short-term funds cheaply from central banks and lending them to clients at higher rates over the longer term.

"Banks had faced a perfect storm, which was low growth, concerns around asset quality, low levels of trading volumes, regulation, negative interest rates and an ever flatter yield curve that was destroying their net-interest margin," said David Riley, head of credit strategy at BlueBay Asset Management in London.

"Each of those has now dissipated. "Companies in Europe rely heavily on banks for financing; a study by the Centre for European Policy Studies, a think tank, estimates that 77 percent of their funding needs are met by bank lending.

That compares with just 40 percent in the United States, where firms make greater use of corporate bonds. On a relative basis, that makes the health of Europe´s banks far more important for the region´s companies and wider economy.

Profits at European banks have more than halved since 2008, while those at U.S. peers have recovered from the crisis that followed the collapse of Lehman Brothers and hit record highs last year.

Now, better economic growth in Europe along with a healthier banking system would reverse trends that have plagued the region´s prospects in recent years.

While risks remain, in particular high levels of bad debts at Italian banks and uncertainty around Britain´s exit from the European Union, the backdrop for the banks as a whole has improved.

Net interest income, a key gauge of bank profitability, is likely to trough in the first half of the year for European banks, according to analysts at Morgan Stanley.

They rate UBS of Switzerland, along with Spain´s Bankia and CaixaBank as among their top stock picks in the sector.

"Three Rs - Reflation, Restructuring and Regulations - will make 2017 a pivotal year," the analysts said in a note to clients.

Steepening government bond yield curves across the globe as investors bet on higher inflation, economic growth and greater state spending are also turning into a tailwind for banks.

The curve steepens when the gap between long-and short-dated yields widens, often reflecting a broadly healthy economy and financial system.

The gap between two-year and 10-year yields in Germany, the euro zone´s benchmark issuer, is at 96 basis points - almost double where it was six months ago.

That spread shares a close relationship with banking stocks in the euro area. Typically, investors demand higher yields for lending to governments for longer periods to compensate for the greater inflation and credit risks.