By Liam Proud
LONDON, Jan 26 (Reuters Breakingviews) – It is undeniable that Europe’s banks have earned their reputation as financial assholes. They earned their low stock valuations through years of risky lending, business slip-ups and excessive financial engineering. But investors may be overlooking the extent to which banks like Deutsche Bank and others have righted their mistakes over the years.
Major euro area and UK banks are trading at a 40% discount to the region’s benchmark, using Refinitiv price/forecast ratios. In a sense, it’s no surprise: history says it’s a bad idea to take a position in bank stocks in an economic downturn like the one ahead. Banks were at the epicenter of the 2008 crisis, and many needed a bailout. The subsequent eurozone crisis of 2012 triggered a wave of bad debts that weighed on its results.
With slowing growth and the warning from the head of banking supervision of the Banking Union, Andrea Enria, that customer defaults will increase, investors seem to take it for granted that the same thing will happen again. But the banks deserve more credit for their rehabilitation, which could be considered a kind of six-phase recovery program.
First, European banks have eliminated many bad loans. According to Bank of America analysts, a decade ago about half of banks’ so-called credit losses actually came from the impairment of loans that had already defaulted but were still on the balance sheet. More recently, however, eurozone banks have faced up to their past sins and dumped bad loans. Credit goes to eurozone regulators, who encouraged them, and to states, who often guaranteed sales. This cleanup will now help executives like Andrea Orcel of UniCredit.
Second, they are being more careful when making new loans. There is no indication that banks have jumped in to lending, despite years of record low interest rates. Between November 2012 and November 2022, euro area banks’ total lending to households and businesses grew at an annual rate of less than 2%, a fraction of its pre-2008 pace. Meanwhile, Britain’s largest bank then Royal Bank of Scotland now called NatWest it has a balance of barely a third of its previous size.
And when they make loans, they now take less risk. Let’s start with retail loans. In the euro area, the sector’s exposure to relatively risky consumer finance has decreased as a percentage of the total, while the share of mortgages has increased. This is useful for banks as borrowers are much less likely to default on a mortgage loan, which could result in losing their home, than on unsecured debt such as credit cards, which contrasts with the United States, where consumer finance has skyrocketed.
Clients, for their part, are in a better condition. Banks across the region have been phasing out variable-rate mortgages in favor of fixed-price ones, helping to insulate borrowers from the immediate cost of higher rates. A combination of lockdowns by the COVID-19 and state support programs have also caused the savings rate to rise in most major economies. This means that households have a much larger cash cushion to help them weather a downturn.
Although companies are still risky, it is now a shared problem. Banks have a problem when small and medium-sized businesses fall on hard times, as they are more likely to fail than large borrowers. But since public institutions guaranteed so many loans during the pandemic, much of the risk now falls on the state. According to Jefferies, almost a tenth of the loans to non-financial companies in BNP Paribas and Société Générale have a state guarantee. The same analysts estimate that Intesa Sanpaolo, Banco Santander, BBVACaixaBank and UniCredit have taxpayer support for between 10% and 22% of their loans to local companies.
Finally, banks have tamed some of their historically more delicate habits. In 2008, losses from large commercial and investment banking bets on assets such as leveraged buyouts and mortgage bonds increased. There are still sources of risk in these areas: BNP Paribas, for example, supported the purchases of the social network Twitter and the British supermarket Wm Morrison, and could keep part of that debt.
But others have withdrawn. According to Refinitiv, in 2007 eurozone and UK banks held nine of the top 20 global rankings for underwriting leveraged buyouts, up from just three of them last year. Deutsche Bank, a former basket case, has massively reduced its exposure to credit risk. European investment banks have also reduced the proportion of their balance sheets available to traders, reflected in the amount banks could lose in a day, known as “value at risk.” This reduces the risk of a mortgage crash like the one in 2008.
With the help of this cleanup, and thanks also to higher revenues from the rate hike, analysts estimate that the big banks in the euro area and the UK will generate substantial profits next year, equivalent to more than 10% of the tangible capital. This figure is higher than at any other time in the last decade. And since investors typically demand a minimum return of 10% to own bank shares, it should be enough to justify valuations in line with the book value of publicly traded banks.
But it’s not like that. The region’s banks are trading at just two-thirds of their tangible book value, despite having outperformed the broader European benchmark of late. Investors may want to see banks’ new virtuous habits stick, and that they can weather a potential downturn without too many scratches. But given the banks’ efforts to behave well, expecting them to repeat the same habits seems unfair.
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