Bad banks doing good quietly

Stock prices have already rebounded. Banco Santander SA, one of the worst stocks of major European banks, has risen by a fifth in the past 12 months. Societe Generale SA more than doubled. The Euro Stoxx Banks index rose by 50%.

But there are likely more gains to come: valuations are still very low, especially relative to US peers. For a long time, many investors looked at the mismatch and saw it as a value trap – European banks were cheap for a reason: earnings weren’t going to improve anytime soon. Negative interest rates, high costs and seemingly irremovable piles of bad debt added up to a bad proposition.

Now, it is true that return on equity forecasts are still below 10% for the next two years at many eurozone banks, which is roughly the level generally assumed to be the cost of capital for a bank or the returns shareholders should expect. By comparison, JPMorgan Chase & Co achieved a return on equity of 19% for 2021, while Swiss bank UBS AG achieved a return of nearly 13%.

Yet the shares of many European banks are trading at a steeper discount to expected book value than expected returns would suggest.

Another way to look at valuations is as a multiple of earnings. Earnings expectations have jumped faster than stock prices in recent months as interest rate hikes become more likely. Price/earnings multiples fell even as bank stocks rallied.

For example, look at Deutsche Bank AG: it may still have a lot to prove to investors, but many are clearly unaware of better earnings expectations: the German bank is trading at half the earnings multiple it had last March .

As life returns to normal following the Covid pandemic, lending is expected to pick up again. Banks are expected to derive more revenue from their core business as the European Central Bank finally moves away from its long history of negative rates.

But that’s only part of what makes life better.

They repaired their balance sheets by getting rid of bad debts and cutting costs. UniCredit is a poster child for this effort. In 2017, the Italian bank raised about $14 billion from shareholders to help solve its problems. Now it has pledged to return more than $18 billion in dividends and share buybacks to investors by 2024, including $4.3 billion this year.

BBVA is buying back billions of shares and BNP will do so once it completes the sale of BancWest, its US business.

Regulators have finished raising European capital requirements and banks are now all ahead of what they need to be, some by a long way. At European and British banks, returns on capital to shareholders over the next two years could amount to more than 130 billion euros ($148 billion), according to analysts at Bank of America.

Beyond loans, banks have been forced to find other sources of income by the long years of negative interest rates. They collect more fees for things like wealth and asset management or insurance, which increases profits even before rates rise.

Of course, there are risks. Investors still remember the catastrophic loop that tied the fates of over-indebted European governments and weak banks into a highly destructive, self-perpetuating tangle. Italy suffered particularly from the debt crisis of ten years ago.

These issues have not been completely resolved, but they have been diluted considerably. Italian banks still hold plenty of Italian government bonds, but the ECB holds more and is not about to start selling any. As the central bank changes its monetary policy to contain inflation, the ECB will be watching closely the very large difference between the government bond yields of Germany and more indebted countries like Italy or Spain.

The ECB has also supported banks by paying them both to borrow money under its targeted long-term repo operations and to deposit a large part of it at the ECB. This policy will end, but banks should replace it with normal loan income and with better margins.

Bad debts could also return if or when European economies slow down, but there too there have been reforms, particularly in Italy where a sluggish bankruptcy regime has made bad debts harder to move. As long as the changes are fully implemented, it will be much easier and faster for Italian companies to restructure their debts when they start to struggle. In the past, the only choice was the bankruptcy court, which depending on where you were in Italy, could take over a decade to reach a conclusion.

Eurozone banks are not ready to beat the returns of their US rivals, but they are pulling themselves out of the quagmire of the past decade. It’s time to start looking at their valuations more as an opportunity than a trap.

More from Bloomberg Opinion:

Deutsche Bank’s 2021 results are half the climb: Paul J. Davies

The ECB is no longer a lone dove: Marcus Ashworth

Bond market turmoil should give ECB pause: Mark Gilbert

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Paul J. Davies is a Bloomberg Opinion columnist covering banking and finance. He previously worked for the Wall Street Journal and the Financial Times.