August 28, 2023
Stress tests have helped reassure investors, but Fitch is creating doubts
Quarterly results benefit from rate rises ... for now
The number of non-performing loans is rising
While government and regulatory decisions limit the sector's visibility

CHART OF THE WEEK: "European banks narrow their valuation gap"


European banks are still trading at lower valuation multiples than their US counterparts (see the chartof the week). Since March, however, this discount has faded. The debacles of Silicon Valley Bank andFirst Republic, the lack of visibility in the run-up to the implementation of Basel IV, and the downgradingof credit ratings for the sector and for US banks by the rating agencies are all uncertainties that areweighing on share prices.

Stress tests have helped reassure investors, but Fitch is creating doubts

The 23 US banks subjected to the Fed's stress test have all demonstrated the resilience of theircapital in the event of a very unfavourable scenario in the economy and financial markets. 6 banks ,including JP Morgan, Bank of America, Goldman Sachs, M&T Bank, PNC and Wells Fargo, surprised onthe positive side with their stress capital buffer (SCB) revised lower. On the other hand, 4 banks withgreater exposure to consumer and real estate lending are expected to raise their SCB: Capital One Financial, Citizen Financial, Truist Financial and Citigroup (see Fig. 2).

Fig. 2 - Improvement or deterioration in capital requirements under stress

In addition, Fitch, which recently downgraded US government bonds, is also considering revising its overall rating for the banking sector from AA- to A+. This revision could lead to downgrades for US banks including JP Morgan and Bank of America. At the beginning of August, another rating agency,Moody's, had already downgraded the credit ratings of 10 regional banks and announced the possibility of down grading a further 17 banks, including Truist Financial and US Bancorp. Finally, on August 22nd, S&P Global Ratings cut the credit ratings of KeyCorp, Comerica, Valley National Bancorp, UMB Financial and Associated Bancorp.

The reason given: rising interest rates are jeopardising banks' profitability because customers are shifting their savings to accounts paying a higher rate of interest,thereby increasing the banks' financing costs.In Europe, the results of the stress test were also better than expected. The balance sheets of the 70banks that took part in the test are of much better quality today than they were ten years ago, despitehigher costs. Dividend payments and share buy-backs should therefore continue, or even increase,leading to higher returns for shareholders of European banks.

Quarterly results benefit from rate rises ... for now

The 2nd quarter results were positive for US and European banks but lacked enthusiasm in the face of normalising credit default rates and the impact of inflation on margins. Households are continuingto consume, entertain and travel without denting their savings, even though credit card debt is on therise and arrears are at an 11-year high (see Fig. 3). A deterioration in the job market, high interest ratesand the resumption of student loan repayments could quickly put a strain on US household savings.

Fig. 3 - Credit card delinquency rate in the United States (%)

The consensus is to expect European banks' net interest income (NII) to peak in 4th quarter of 2023,while the quality of banks' assets will very probably start to deteriorate. Investors are now focusing more on 2024 results, which could disappoint.

The sector is therefore unlikely to see an expansion invaluation multiples over the next few quarters.Irish, German, Spanish and Italian banks benefited the most from the rise in key rates and their positiveimpact on net interest income. Results for the 2nd quarter surprised on the upside, while flows intointerest-bearing savings solutions weakened compared with the 1st quarter. Margins thereforeremained stable, while revenues rose. Returns on equity also surprised on the upside, with a numberof banks, including Deutsche Bank, BBVA, Barclays and Caixabank, announcing new share buybackprograms. High returns on capital should continue into 2023, but the risks in 2024 are more bearish. Banks in the United Kingdom are experiencing pressure on margins due to the flight of bank depositstowards more lucrative savings solutions. In France, the rise in interest rates is generating very little operating leverage for banks. In fact, the French government is regulating banks' ability to raise mort gage and lending rates to protect households and businesses.

This policy does them a disservice when rates are rising, but it also protects them by slowing the deterioration in the quality of bank loans. Finally, Nordic banks are suffering from their exposure to commercial property, and the quality of their assets, which are largely exposed to variable lending rates, could deteriorate more quickly

Non-performing loans starting to rise

There are no signs yet of a general deterioration in credit, but many US banks have reported pocketsof stress. Most banks maintained their net charge off (NCO) forecasts during the 2nd quarter and 2023results and loan deficiency reserves remained roughly stable for the group. That said, a handful ofbanks recorded sequential increases in losses linked in particular to loans in the residential propertysector. These include Citizen Financial and M&T Bancorp.In Europe, non-performing loans remain at historically low levels. But default rates began to rise inthe second half of last year (see Fig. 4).

Fig. 4 - Non-performing loans as a percentage of total loans by European banks (%)

Government and regulatory decisions limit the sector's visibility

Rising interest rates will put more and more pressure on governments as the service of their debtincreases, while inflation weighs on spending. To balance their budgets, governments are starting to taxsectors that have made exceptional profits as a result of rising interest rates. In 2022, oil companiessuffered the same fate when energy prices soared as a result of the war in Ukraine.In Italy, the introduction of a windfall profits tax has raised market fears that such a tax could beextended to other European countries. Spain, Sweden, Denmark and the Czech Republic have alreadytaken similar measures (see Fig. 7).In addition, against a backdrop of high interest rates and an increase in bank profitability, the European Central Bank has decided to change the terms of the TLTRO (Targeted Long-Term Financing Operations),reducing the remuneration of reserve requirements to 0%.

This change will come into effect at the start ofthe reserve maintenance period on September 20th. Minimum reserves are reserve balances that banksare required to hold with the ECB. The minimum amount is equivalent to 1% of their liabilities, mainlycustomer deposits. Minimum reserves are currently remunerated at the deposit facility rate (DFR), i.e.3.5%. These changes should reduce banks' net income by around 2% on average.

Fig. 7 – Windfall Taxes on banks implemented (or in the process of being approved) in Europe

In the United States, the implementation of the Basel IV regulations will require some additionaladjustments to capital requirements, despite the good stress test results. US banks are thereforeunlikely to increase their share buyback programs over the next few quarters.

They have also begunto strengthen their balance sheets by reducing risky assets. As a result, bank lending is slowing sharply.

Conclusion :

The regulatory burden of the supervisory authorities, the implementation of windfall taxes and thedowngrading of the sector's credit ratings by the rating agencies are strong headwinds for the banksbeyond the cyclical aspect generated by rising interest rates and inflation. However, the sector is strongerthan it was during the great financial crisis, with stronger capital ratios and increased supervision.European banks are ahead of the game in regulatory terms, applying more stringent prudential rules. Asa result, they seem to be in a better position to cope with the next economic downturn than the USregional banks


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