Bankrolling the Eu­ro­zone re­cov­ery

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

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.

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