Credit Suisse – August 11, 2011
In the middle of the storm
Over the last few days the sovereign crisis appears to have entered a new phase with the S&P
downgrade of the US and Italian 10-year bond yields trading through 6%. On Sunday night the
ECB met and investor concerns are focussed on the size and shape of intervention this week.
With this backdrop, the banks will continue to be in focus and below we go through our thoughts
for the sector and for the stocks;
¦ For the sector as a whole we see several key themes;
¦ 1. Overall, for the European banking system the funding position is better now than
what it was at the start of the previous crisis however there are still significant wholesale
funding needs, even within the retail banking sector. This will drive the volatility and means
that the earnings outlook and fundamental valuation is highly uncertain.
¦ 2. From a capital perspective banks are also generally better capitalized, although
banks have been using transition periods to achieve Basel III capital requirements. Regulators
may ultimately respond to this crisis by delaying implementation, nevertheless we think that
credit markets will require recapitalization sooner, potentially limiting upside.
¦ 3. Putting this together, the market has already stepped away from management targets,
but at this stage earnings visibility has become even more limited and hence the sector
will require very meaningful intervention in order to support it.
¦ In terms of intervention, we would not rule anything out. The initial focus is on the scale of
Italian (and Spanish) bond purchases by the ECB and for example a strong sign would be if
the ECB were to come in at the 10 year, which is where the stress is most apparent. Beyond
that the banks may still need additional liquidity support. The key is the capacity of the ECB to
provide this. Similar to TARP though, we would expect to see several stages of
intervention, with the remit of the authorities widened as events unfold, potentially even
via direct capital injection. The issue Europe has relative to the US is the additional political
process that needs to be overcome.
¦ In summary, whilst optically looking cheap we expect European banks to trade based on
short term news flow. In terms of data points to watch over the next week; (i) today there will
be a call by S&P, which will talk more broadly about the implications for the US, including a
review of the US government sponsored entities; (ii) tomorrow, there is the meeting of the
FOMC - whilst (clearly) rates can't be reduced, it will be important to see if there is any sign of
more dovish language, especially regarding QE3; (iii) on Wednesday, S&P will be hosting
another call about broader ratings implications - the press is already speculating about
growing market concerns about France; (iv) with this latter point in mind, there is likely to be
considerable attention on French Q2 GDP numbers on Friday (12/8), where consensus is
currently at just 0.3% growth.
¦ European banks will remain among the highest beta sectors and we believe it is too
early to have visibility ahead of intervention and unclear valuation. Having said that,
within this space we would view the most news flow sensitive as the Italian banks,
followed by the French. On the UK, whilst in some ways further from the storm, given
wholesale funding requirements we would expect them to remain volatile. On valuation,
with the sector trading on 0.9x 2010 tangible equity, the sector is optically cheap, but is
not discounting extreme stress. We would caution against an extended bank rally as
clearly the return prospects of the sector are deteriorating as we speak and write given
a deteriorating macro economic background.
Below we provide a short comment on a country by country basis including thoughts on stock
From a macro perspective, Spain seems to be largely on track YTD to reduce budget deficit to
6.5% by YE11, though Q2 GDP reading last week (0.2% qoq) is a clear reminder or how sluggish
the recovery is proving, with private consumption/public spending/construction still under severe
pressures and only exports performing well. Over the weekend, some further measures were
announced but in general, it feels the current government is at a stage where additional bold
measures are unlikely and "external help" (ECB buying bonds, EU accelerating the proper set up
of the EFSF mechanism) is needed to control the situation, especially in light of the general
elections having been brought forward to November.
Interestingly, and probably due to the lack of incrementally negative news flow and the country's
lower debt to GDP ratio (which makes an increase of funding costs less traumatic in the short
term), the pace of deterioration in recent weeks in sentiment terms has been less significant for
Spain than has been for Italy, with Italian risk premium standing above Spain's last week for the
first time in 15-18 months.
For the banks, there are two issues standing out at this point in our mind;
(1) Recent escalation of sovereign yields was reaching dangerous levels for banks in terms
of their access to the short term repo market through clearing houses (especially LCH) the
channel the sector has been using to "escape" from the stigma of having to borrow
excessively from ECB. A potential decline of government yields away from 450-500bps
premium vs. Germany needs to be seen as good news in order to avoid a short term liquidity
squeeze, though funding remains a big structural hurdle across the sector, with medium/long
term debt channels still shut down for Spanish banks;
(2) Secondly, although in the past weeks the market focus has been elsewhere we still
believe a bolder approach by banks in terms of NPL/loss recognition would be taken
positively, with our recent research flagging SAN/BBVA resilience and the material increase
of profitability for banks like POP or SAB in a scenario where property losses are up-fronted,
given their structurally better efficiency and comparatively solid capital ratios at this stage.
Given banks‟ reluctance to bite the bullet on a standalone basis, M&A still looks as the less
painful option for most players (and the auction of CAM after the summer potentially kicking
this process off).
On a stock specific basis, in a reasonably constructive world (i.e. markets viewing potential ECB
intervention positively), Santander and BBVA both look oversold to us here, though we would not
chase them aggressively as they have not really underperformed the sector in the last 7-10 days.
In Santander‟s case short term earnings momentum is negative and capital discussions are
unlikely to fade in light of the bank's lower earnings generation post PPI charge, elevated
dividend payout ratio (65-70%) and internal capital imbalances across units. On Popular and
Sabadell, despite recent weakness, we remain negative given comparatively high valuations and
unrealistic coverage of bad assets.
Against a rising tide of nervousness, which has seen yields increase sharply in the last month, the
Italian government has stepped up the pace of economic reforms. Following an extraordinary
budget 2-3 weeks ago, we saw another announcement on Friday in response to last week's
market reaction, which include the following measures; (i) the addition of a balanced budget fiscal
rule in the Italian Constitution, (ii) the acceleration into 2012-3 of some of the measures that had
been approved by Parliament and scheduled for 2013-4 (5% cut in all tax expenditures in 2012
now and a 20% percent linear cut in 2013) and (iii) yet to be specified „pro growth" measures,
which could include labour market reforms and liberalisation of protected professions and several
Our Economics team has argued that in the absence of a material deterioration of growth
indicators (current estimates of GDP growing c.1% p.a.), Italy's primary surplus and low deficit
figures would be enough to stabilise and eventually bring down the country's elevated det/GDP
ratios (c.120%). Hence, growth is the key indicator to monitor from now on, with Q2 GDP
announced last Friday rising 0.3%QoQ, in line with market expectations, though the front loading
of the fiscal measures will inevitably have a negative impact on future growth.
For the banks, other than the associated risks attached to a more serious debt crisis episode, we
see the sector's structurally low profitability aggravated by ongoing news flow on two fronts:
(1) The uncontrolled increase of sovereign costs has a proportionately larger impact on
Italian banks' funding costs, as retail bonds (25% of total funding) are linked to government
yields, as opposed to the traditional link to Euribor seen in countries like Spain or Portugal for
(2) Lower GDP growth rates and a shorter tightening cycle by the ECB are likely to have
negative implications on Italian banks in the shape of smaller margin uplift and provisioning
decline than initially anticipated. Finally, we also note Italian banks' exposure to the public
sector (bonds and loans) stands at 5-15% exposure of their total balance sheet.
We would caution against an extended share price out performance of Italian banks, given the
prospects of low profitability under rising funding cost pressure.
The markets focus post US downgrade is now turning to the rating of France which has a
marginally higher debt to GDP ratio than the US – YE 2011E France will be at c.87% and the US
will be at c.86% adjusting for state budget deficits. Clearly, this is very important in the European
context as essentially it is France and Germany that are currently funding the rest of the region. In
terms of bond yield at 3.2%, the market is still giving France a defensive status.
According to an interview given by S&P over the weekend it seems that their rating for France will
remain unchanged until May 2012, which is when the French presidential and parliament
elections take place. Having said that, this will increase pressure on all parties to present credible
budget plans in the run up to the election and we believe rating agencies will keep a close on that
ahead of the French budget presented in September.
On the French banks themselves, the US downgrade should have a marginal impact, but the
concerns will remain on Italian exposure, as BNP Paribas and CA SA have some retail
businesses in Italy – Italian PBT as a percentage of total Group earnings is c.5% at BNP (2011E)
and 5.4% at Credit Agricole 2011E. In terms of regulation it will be interesting to see how Basel
III will be implemented under this type of economic background. We would view any softening
and/or delay of capital and liquidity rules as a positive for French Banks as they are mostly
perceived as just above the minimum requirement by investors.
In general we would view the UK as a relative safe haven given fiscal independence, however the
UK banks have significant funding needs and hence are dependant on what happens in credit
markets. Further, they are impacted by additional concerns such as the debate on ring fencing
and the much awaited final ICB report (due 12 September). Whilst, based on our estimates they
would not need to raise additional capital, this is dependent on functioning wholesale funding
markets and the ability to use implementation periods. For instance at YE 2010 Basel III fully
loaded capital ratios were just above 6% for the UK domestics although above 10% by 2014E.
Funding positions are better, but structurally the UK market has a significant funding gap. We
note that the Bank of England could step in if the UK banks were to experience problems e.g. by
extending the SLS and credit guarantee scheme.
On a stock specific basis, post a week of earnings releases where Barclays was stronger than
anticipated, Lloyds was weaker and RBS in line overall, in the short term we see Barclays as the
most attractive. Having said that, whilst longer term there are headwinds, in the short term given
this environment the Asian banks are likely to continue to trade as safe havens.
As the original European bailout country, we see the Greek banking sector as potentially most
geared to a significant peripheral bailout. Additionally the Greek banking sector has been fairly
valued on a fully diluted mark-to-market basis for Greek government bonds for at least nine
months, so we do not see downside risk on any mark-to-market exercise: the mid-sized Greek
banks are trading on headline P/TNAVs of 0.3-0.4 for instance, and the existing FSF covers the
recapitalisation requirement of around €10bn on our estimates. Our note of 27 July “Greek
Banks: Fiscal Transfers” showed that over 60% of the share price moves in Greek banks since
the Greek bailout last year are explained by GGB prices alone.
Nevertheless, downside risks still exist from a worsening economic background leading to lower
loan growth and (even) higher impairment charges. The Greek deficit is still running much higher
than the IMF‟s 2011 target of 7.6%: perhaps as much as 10% ytd. Finally, we also see the
public‟s patience with austerity wearing thin by the end of the year.
Although again very geared to a bailout, we do think the story here is a little different to the Greek
banks, as Irish sovereign exposure is still being treated as close to a par asset (this is a
philosophy we agree with given the potential protection from a layer of senior bank bonds in fully
nationalised banks which in our view would be written down before government debt.) The Bank
of Ireland story relies on sufficient generation of PPOP and sufficiently low impairment charges
between now and 2014. Both of these are reliant on economic recovery in Ireland, and as Ireland
is a particularly open economy and so reliant on some type of recovery in Europe.