Bankrolling the Eurozone recovery
Europe’s banking sector has been catching the eye with 18 out of the 31 banks in the STOXX Europe 600 reporting positive earnings surprises and almost all beating sales targets. It may be too early to declare Europe’s banking sector as being off to the races after a seven year nightmare that started in August 2007, but we see three big trends in the results.
In Spain and Ireland, cheaper funding has driven interest income growth—this stems from more friendly wholesale markets and the European Central Bank’s TLTRO program which lets banks borrow at just 0.05% until 2018. Spain’s second biggest bank BBVA tapped the ECB for EUR 4 bln in 2Q15 while Barcelona-based Caixabank has, since last September, snaffled EUR 16 bln and Italy’s Unicredit, EUR 18 bln. In total, the TLTRO has provided EUR 384 bln of funding, mostly to peripheral banks.
The periphery looks to be in a virtuous circle with recoveries in Spain and Ireland especially strong (growth was 3.1% and 6.5% respectively in the last year). This is reinforcing the improvement in financial conditions and reducing the incentive for depositors to squirrel funds in time deposits. As the recovery raises transactional demand for cash, the effect can be seen in monetary aggregates with M1—overnight deposits and currency—rising relative to the broader M2 measure. On the demand-side, loan volumes are improving due to better business sentiment as renewed profit growth spurs investment; job growth has boosted disposable household income, causing more interest in the mortgage market.
The picture is different for banks in core economies such as France and Germany which face an interest income squeeze due to low rates. Societe Generale saw its net interest income fall 8.6% to EUR 4.54 bln in 1H15. Higher fees have partly offset this squeeze, but the big boost for Europe’s bulge bracket has come from strong investment banking, advisory and trading activities. Looking forward, as Europe’s recovery deepens higher loan volumes should support net interest income despite tight margins.
Lastly, the impact of tough restructuring is flowing through to the bottom line via lower loan-loss provisioning. The latest results show banks making inroads with Caixabank and Bankia in Spain cutting their non-performing loan ratio to 9% and 12.2% respectively in 2Q15 compared to 9.7% and 12.9% in 3Q14. Bankia was formed in 2010 as a product of seven troubled regional banks and hence has an especially high share of NPLs. Elsewhere, the Bank of Ireland (a commercial bank) reduced the volume of defaulted loans by EUR 1 bln from 2Q14.
Looking forward, profitability should improve further. Banks will continue to cut costs and use capital more efficiently, partly due to tighter regulatory requirements and low rates—it is encouraging that the net-income-to-riskweighted-asset ratio has improved. As such, the story is of general pick-up, reflecting the steady European economic recovery. To be sure, banks are not out of the woods, especially in Italy where the NPL ratio remains at about 18% and the government is only now getting serious about reforming the sector. But in February a bill was passed to overhaul governance at the ten largest cooperative banks and resolution of the NPL problem should be aided by a planned overhaul of Italy’s inefficient bankruptcy process.
To put it in perspective eurozone banks can be seen as being at a similar stage to Japanese banks in 2002-03. After trying every other alternative, Japan learnt that the only way to fix a broken banking system is to reduce NPLs, recapitalise banks and help the private sector deleverage. All these things are now occurring in Europe and are supported by structural reforms to boost growth prospects especially in peripheral countries. When Japan finally got serious about fixing its banks it led to a period of outperformance versus the TOPIX. We believe Europe’s banks, which are up 3% versus their benchmark since the start of March, are starting to do the same thing.