A recent trip to Europe – 3 days in London at a European financial services conference, and 1 day field trips to Frankfurt and Madrid – gave us an opportunity to meet with executives from more than 25 financial services companies and agencies (including 19 banks and 3 insurers) representing 9 countries. Notably, the trip reinforced our European investment thesis, although a disparity of country and subsector specific issues remain, leaving different companies (and countries) at different stages of recovery/normalization. Below, we outline our key takeaways from the trip.
The sector is benefiting from an improving economic backdrop, as the U.K. continues to be one of the best performing economies in Europe. However, many executives expressed concerns about the regulatory environment, most notably with respect to regulatory capital. While heightened capital/leverage requirements and compliance have caused some universal banks to retrench and abandon non-core product segments, returning capital to investors remains a focus. The retrenchment process of the universal banks has prompted many smaller companies (challenger banks, consumer finance companies) to try to take advantage of the void left in their wake.
The country’s improving economic environment (Spain’s GDP growth rate has been positive and rising for 6 straight quarters) is translating into improved front book loan growth (i.e. new originations), however, it is not yet sufficient to offset the roll-off of the back book (i.e. loans already on the balance sheet). Although many banks believe the upcoming general election (since confirmed as Dec. 20, 2015) has postponed some businesses from seeking new loans, the election was not a significant concern — the early peak of the radical socialist (and anti-austerity) party, Podemos, has left few bankers concerned that they will have any great showing in the election (unlike their Greek cousin, Syriza). Similarly, the banks felt the ECB’s review of deferred tax assets (embedded into regulatory capital) was “yesterday’s story” and didn’t expect a negative capital outcome (in fact, the ECB and Bank of Spain have since grandfathered the practice, effectively removing the risk of associated capital raises).
Recent modest growth in the economy is a positive sign but not the focus of the popolare banks (Italy’s version of cooperative banks) at present. Legislation passed earlier this year forcing them to become stock companies by 2016 year-end has incited consolidation efforts. We met with three of the 10 popolare banks affected by the legislative change – all spoke freely about M&A, with two indicating that announcements before the new year were highly possible. The other topic du jour was the government’s proposed ‘bad bank’ and its implications for the sector. While most agreed that the details were still too lacking to express any certainty on their participation, all agreed its implementation would be a positive, particularly in its ability to narrow bid/ask spreads on non-performing loans.
Questions with regards to the impact of a Chinese slow-down weighed on investors’ minds, but the regulator and banks thought that the market reaction to such an event was thus far overblown. The banks seemed less concerned about the economic environment – which was described as ‘relatively bright’ – and more internally focused on cost-cutting measures/strategic plans.
The upcoming results of the Supervisory Review and Evaluation Process (SREP) was a frequent topic, although when and what would be disclosed, and by whom was uncertain (the ECB will not have a detailed release, and not all banks indicated they would disclose their own feedback). SREP’s key intent is to verify that banks have sufficient systems, capital and liquidity to cover their risks. Although we expect a number of European banks may raise equity in the next two years (as they attempt to reduce their leverage ratios), we continue to believe the risk of dilutive capital raises is limited given that tangible common equity for the European banks has doubled since the cycle began.
Central and Eastern Europe
Central and Eastern Europe (CEE) was viewed by many banks as a great opportunity for growth, however political risks keep most on the sidelines.
Unlike in most other European countries where the cost of risk continues to decline (providing a significant support to the earnings recovery theme), several Nordic banks indicated that their countries’ credit cycles appear to have bottomed and expect several quarters of credit quality stability.