European banks in the post-AQR landscape

FLASH
European banks in the post-AQR landscape
Pictet Asset Management I October 2014
For professional investors only
Sunday’s results from the European Central Bank’s banking health checks revealed around
one in five of the region’s top lenders was short of capital at the end of last year but many
have since repaired their finances. Stefano Nora, head of sector research at Pictet Asset
Management, discusses the outlook for Europe’s banking sector and credit growth.
The Comprehensive Assessment, which combines asset quality review and stress
test, confirms that European banks have substantially strengthened their balance
sheets. We believe this is a necessary condition for restoring economic growth, but
banks are not out of the woods yet and they are likely to remain cautious about
increasing their lending or returning capital to shareholders.
Stefano Nora, Head of Sector Research
• The ECB’s health checks show banks have
substantially strengthened their balance
sheets.
• Increased transparency is likely to help
reduce the implied risk premium of strong
banks.
• Banks are likely to boost lending only
gradually; more support from ECB and
governments needed.
The outcome of the stress test overall contains no negative surprises. The ECB
has said the region’s top 130 most important lenders were EUR25 billion short of
capital at the end of last year – at the lower end of expectations. And the amount
of new money needed to plug the capital hole falls to less than EUR7 billion after
factoring in capital raising in 2014. Among the listed banks, only two Italian banks
ended up with a capital shortfall post-stress test and their capital-boosting actions.
Unlike previous European stress tests, the Comprehensive Assessment this time
was detailed and thorough, in our view. It will create transparency on the state
of banks’ balance sheets and help reassure investors about the resilience of banks
to stress scenarios.
This should translate into a lower equity risk premium – the excess return
on equity over the risk-free rate. The equity risk premium of the banking
sector stands around 10 per cent, above the long-term average. The increased
transparency as a result of the assessment is likely to reduce the implied risk
premium, particularly for banks that pass the test with a comfortable margin.
We believe a more transparent balance sheet for the banks would help investors
better differentiate their cost of equity.
But is this the end of the cloud hanging over Europe’s banking sector and is credit
lending going to grow rapidly in the region? It is unlikely to be the case, in our
opinion.
Firstly, the AQR does not mark the end of capital assessment. In November, at
the Group of 20 meeting in Australia, regulators will discuss a new rule requiring
banks to hold safety buffers of “bail-in” bonds – debt which can be written off or
converted into equity in the event of a bank failing -- and other capital equivalent
to 16-20 per cent of their risk-weighted assets. The rule on the minimum Total
Loss Absorbing Capacity (TLAC) is due to be phased in by 2019.
We also expect the European Banking Authority to plan an assessment of risk
weighted assets calculation in 2015 and to run the stress test on a yearly basis, in
line with the US Federal Reserve’s practice for US banks.
In theory, banks that pass the stress test with a comfortable margin could be
allowed to return more capital to shareholders in the form of dividends. However,
an intensifying wave of risk assessment and stress tests is likely to make banks
more cautious about their payout plan, particularly in the short term.
Secondly, in terms of the wider economy, Sunday’s results do not remove concerns
about the region’s slow growth and stubbornly low inflation that is far below the
ECB’s target of just under 2 per cent. Pressure is likely to increase on the central
bank and euro zone governments to do more to help boost the economy and
foster lending to businesses.
1 | EUROPEAN BANKS IN THE POST-AQR LANDSCAPE | OCTOBER 2014
FIGURE 1 - EURO ZONE CREDIT FLOW BOTTOMING OUT?
12 —
— 100
8—
— 50
4—
—0
0—
-4 —
— -50
-8 —
-12 —
— -100
2007
2008
2009
2010
2011
2012
2013
2014
Total private credit flow (QTLY, % GDP) [0.5%]
Of which: bank credit flow (QTLY, % GDP) [-0.9%]
Of which: nonbank credit flow (QTLY, % GDP) [1.6%]
ECB survey: average credit standard easing (RHS) [-0.9%]
Source: Thomson Reuters Datastream, Pictet Asset Management
From November, the ECB is going to be the sole regulator for the largest
European banks. With its new role, the central bank expects that a combination
of bank health checks, a supply of cheap liquidity under the TLTRO long-term
loan programme and capital relief measures with the purchase of asset-backed
securities will help harmonise the cost of borrowing for small and medium-sized
enterprises and stimulate new lending.
The ECB is already providing cheap money to help banks repair balance sheets
and increase lending. However, under its TLTRO programme, only EUR80 billion
of the EUR400 billion available have been used so far. We expect banks to take up
a bigger amount of long-term loans when the ECB launches the second TLTRO
programme in December.
The next step for the ECB is to provide extra liquidity through its planned
purchase of asset-backed securities and covered bonds to help unclog credit
channels and stimulate lending to the real economy. ECB President Mario Draghi
has said he wants the purchase plans, together with the provision of new cheap
loans to banks, to increase the central bank’s balance sheet towards its levels of
early 2012 – up to EUR1 trillion higher than today. But the ECB is unlikely to
reach this target, in our view. Therefore, further monetary stimulus in the form of
outright quantitative easing still remains a possibility for the first quarter of 2015.
Pictet Asset Management Limited
Moor House
120 London Wall
London EC2Y 5ET
www.pictetfunds.com
www.pictet.com
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2 | EUROPEAN BANKS IN THE POST-AQR LANDSCAPE | OCTOBER 2014

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