European banks are once again facing fears of collapse. Although the current risks require careful consideration, a thorough examination suggests that relatively sound lenders can be found in the market today.
The start of the year was difficult for European banks. The STOXX Europe 600 Banks index fell 22.4% from the start of the year to February 16, despite rebounding in recent days. Investors fear that the quality of bank credit will be affected by a possible
and turmoil in the energy sector, pressure on margins from historically low interest rates and unintended consequences of new regulations. The ability of European banks to generate profits and pay dividends appears to be under threat.
Sharing the rout at all levels
Yet we believe that the European banking sector is generally much better placed to withstand the pressures than it was a few years ago. And the rout in regional bank stocks was also punitive for the strongest lenders.
Clearly, a recession would be a blow to the sector. Profits would evaporate and dividends would dry up. In a global and regional economic contraction, investors do not want to own banks.
However, we believe investors’ concerns about the recession need to be put into context. In December, the European economic sentiment indicator reached its highest level since April 2011. Fiscal policy in the region is expansionary. Of course, there are always risks, but we believe the Eurozone is much better placed than in the past to weather the consequences of any downturn. For example, signals from the European Central Bank suggest that monetary policy could be eased further to combat global risks.
Multiples in distress imply disaster
Investors seem to disagree. Today, European banks are trading at a price/book value of only around 0.7x. Distressed multiples like these have not been seen since the sovereign debt crisis in 2012, when investors feared the euro would disintegrate, leading to an economic implosion in Europe.
No wonder dividends are in the spotlight. Highly rated stocks typically trade at low dividend yields, indicating that investors are willing to pay a premium for dividend sustainability and growth potential. But for European banks, both
and dividend growth indicators are high and have diverged sharply from all other sectors (Display). That means investors don’t believe the banks will be able to sustain their dividend payouts.
Given that banks have gone from crisis to crisis in recent years, investors’ fears are understandable. But, at the same time, many banks raised capital, significantly improved
positions, reduce costs, deleverage and streamline operations. Clearly, the European financial sector is much healthier today.
Stronger balance sheets
Balance sheets are stronger. The ratio of tangible book value (a measure of leverage) to total assets of European banks now stands at 5.4%, double the level recorded during the global financial crisis. Provisions for non-performing loans declined while the return to tangible book value, a measure of profitability, also recovered and stabilized (Display).
However, looking at the entire industry can be misleading. There are large differences in risk profiles, capital positions and dividend-paying capacity between European banks.
Risk profiles differ
To test this, we looked at two groups of European banks with very different fundamentals. While the expected dividend yield was high for each group, the level of confidence in receiving these yields differed significantly (Display). The less risky banks seemed to have much more resilient balance sheets and loan portfolios; therefore, in our view, they are more likely to meet dividend growth expectations.
Profitability is another sensitive point. The bears argue that banks simply cannot increase their profitability when interest rates are so low. Indeed, their core business is based on interest rate differentials between deposits and loans, compressed in the current context.
But there is a flip side, for long-term investors. While monetary policy is expected to remain loose this year, interest rates cannot stay this low indefinitely, in our view. If economic growth eventually picks up in the coming years, we can expect interest rates to eventually rise. And when that happens, European banks will be very well positioned, as they can price deposits and loans more profitably.
makes it difficult for investors to keep their eyes on the longer-term future. Yet we believe that is exactly what investors should be doing now. When valuations are so distressed, we believe that some European banks may be a source of outsized investment returns in the years to come.
The opinions expressed herein do not constitute research, investment advice or trading recommendations and do not necessarily represent the opinions of all of AB’s portfolio management teams. AllianceBernstein Limited is authorized and regulated by the Financial Conduct Authority in the UK.