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Uncertainty in European banking is rife

The European banking sector has faced some well documented challenges since the financial crisis of 2008. Banking is no longer the high profit business it once was. But the outcome of the EU referendum has acted as a catalyst to bring these issues to the fore. Banking now stands at a cross-roads and decisions have to be made.

Bank returns are limited

There are three investment themes driving European bank returns. The first of these is the decrease in yield from government bonds. Now, when government bonds run to maturity many are offering marginal negative returns. This has a knock-on effect to the profitability of bank loans as the yield will also decrease. This is most pronounced in the Euro loan market, aggressive monetary policy from the European Central Bank (ECB) has amplified the problems for those banks concentrated in Europe. Whilst ultra-loose monetary policy could facilitate growth in many sectors the banking sector cannot be profitable with negative rates of interest.

Non-performing loans (NPL) on bank balance sheets is the second theme driving returns. In a business such as banking there will always be a fraction of loans with a high default risk, the problem is not with the existence of NPLs. Instead this issue lies with the size and spread of these across Europe. Data provided by the European Banking Authority in 2015 shows that 16.9% of loans in Italy are NPLs, 18.5% in Portugal, 6.8% in Spain and 20.6% in Ireland. At the end of 2015 the Peterson Institute of Personal Economics estimated that the level of NPLs across Europe is 7.5% of the total loans whilst in the US NPLs account for just 2%.  Italy’s government-orchestrated banking fund, Atlante, exists to recapitalise some of the Italian banks, yet local government schemes such as this do not seem to be effective.

The third investment theme is the low profitability of the banks. According to FactSet data the return on equity (a way of measuring bank profitability) is down 50% from pre-crisis levels. The days of double digit return on equity are gone. Recent financial reports from the banks showed that European banks need to accelerate their cost-cutting programmes in order to increase their revenue. Slow growth across Europe does not help to lift revenue as the cost structures are still too rigid given the physical presence in branches. It seems that European banks will need to truly embrace digitalisation in order to navigate this economic cycle. As compliance costs are set to remain high there seems to be very few drivers of revenue.

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Brexit accelerates the challenges the banks face

The decision to leave the EU has shown us that something has to change. The value of the banks is -36% year-to-date. Some investors may look upon this as an opportunity to buy at market lows. Given that the price-to-book ration of European banks is currently 0.6 they could be right. Any ratio below 1 suggests that if assets were sold more money could be made than current market value.

Something has to change to prevent the collapse of European banks. This is unlikely to come from a redefinition of banking business models, instead it will likely come from a political decision. The largest issue seems to be with the NPLs, credit growth will return but only if the banks are able to get rid of the huge amount of NPLs at a good price. There is no other way to trigger a credit cycle and that solution will need to come at a European level.

There are several proposals on the table, but the main issue stems from who will pay for the solution? Will this be left to taxpayers once again? Or could it be the bond or equity investors who feel the pain? There is a lack of clarity on this, in Italy it seems the Government want to provide public aid, despite this going against European rules. So once again we could see the taxpayers bail out the banks.

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