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European Banks: Surprisingly Resilient So Far
- By James Hyde, Principal, European Investment Grade Research
- December 8, 2020
As new lockdowns and social restrictions were introduced across Europe in October, third quarter European bank earnings were an unexpected bright spot. With some revenue recovery and lower provisions for bad loans, pre-tax earnings increased quarter-on-quarter. Capital ratios improved and non-performing loan ratios were almost stable. While the year-on-year comparison shows earnings at less than half the level of a year ago, there were hardly any banks in our usual investible universe that posted losses. At least part of the out-performance was due to a rise in trading and other capital markets revenues. However, a decline in new loan-loss provisions was the bigger driver of better-than-expected financial results. While we cannot yet sound the “all clear,” we believe that government support has helped the banking sector weather the effects of the coronavirus pandemic far better than might have been expected last spring, thus supporting our overweight positioning to the sector.
Following dismal first quarter results and a patchy set of second quarter earnings, banks largely surprised to the upside in the third quarter. In aggregate terms—for the 31 main quarterly reporting banks within our high grade investment universe—pre-tax earnings rose 53% quarter-on-quarter. (Figure 1) While this meant a -19% decline against the third quarter of 2019, the earnings “beat” versus consensus expectations was almost 50%. However, a bigger surprise related to the cost of risk or credit provisions. On average, these came to only 0.51% of gross loan books and, while much higher than the 0.35% of a year ago, this charge was almost 0.30% less than consensus expectations and down from an average of 0.90% in the first two quarters.
Figure 1: Limited damage to earnings capacity of European banks from Covid crisis
Though unexpected, the decline in provisions is justifiable given a lack of new non-performing loans. The average non-performing loan ratio for our universe came to 2.8%, up just 3 bps in the quarter and down 10 bps year-over-year. (Figure 2) This stability is in large part due the enormous financial support of European governments, which have protected both companies and banks during the crisis by guaranteeing loans, introducing loan payment holidays, and financing furlough schemes to prevent unemployment from climbing sharply.
Figure 2: Non-performing loan ratios very contained so far
A Note of Caution
So far so good, but this is where we need to sound a note of caution on the recognition of non-performing loans. A key matter is the extent of forbearance—both as extended to companies by banks and by regulators to banks. Moratoria and payment holidays that were government-imposed or agreed to by banks on a voluntary basis have played a key role in staving off corporate and household insolvencies. This forbearance has been matched by regulators who have shown some flexibility when classifying loans as either defaulted or with significantly increased credit risk (for which forward looking provisions would need to be set aside). While a good part of these holidays or moratoria ended in most countries over the past few months and with relatively low default rates so far reported, a clear picture of which loans will become over 90-days past due will not emerge everywhere until mid-2021. Only after that will the true cost to bank earnings and balance sheets become apparent.
In a July publication the European Central Bank estimated that in a severe macro scenario non-performing loans could hit €1.4 trillion, well above levels registered during the global financial crisis, and the equivalent of 5.7 percentage points of banks’ capital ratios.1 That seems more remote now but some meaningful provision top-up needs cannot be ruled out.
Improvements in Capital Adequacy, Liquidity, and Image
That said, beyond earnings and asset quality, there were also clearly welcome improvements in capital adequacy and liquidity. For the banks in the universe referenced here, the weighted average Common Equity Tier 1 (CET1) capital ratio increased by 39 bps in the third quarter and by 77 bps from a year ago to 14.4% on a so-called fully loaded basis. (Figure 3) This means that the tendency identified by the ECB for an improvement from 13.4% in 2016 (on a so-called transitional basis) to 14.6% in the first quarter of 2020 has continued. Regulatory and government interventions have played some role in the latest improvement. The mandated suspension of dividends and share buy-backs means greater earnings retention and capital preservation. Meanwhile, there has been relief for the denominator of this ratio (the risk-weighted assets) through the introduction of lower risk weights for some small to medium enterprises and from some maturing loans being replaced by government guaranteed loans.
Figure 3: Capital and liquidity ratios continue to improve
Aggregate amounts held in liquidity pools (cash at central banks and government bonds etc.) now amount to over €6.4 trillion, or 20% of total assets for the universe we refer to. This increased 4% in the third quarter and 27% year-on-year. On average, we estimate these pools would allow for banks to repay wholesale liabilities for a period of 27 months with no access to wholesale funding markets, compared to 20 months on average two years ago. Thus far, the ECB has also injected massive liquidity in support of banks, including the €1.2 trillion increase to its targeted longer-term refinancing operations (TLTROs) and €750 billion Pandemic Emergency Purchase Programme (PEPP). This liquidity has helped spur demand for corporate bonds that enabled companies to repay amounts drawn under their revolving credit facilities during the spring.
There has also been some positive image development, which may help lay the groundwork for further government support. Banks are increasingly seen as part of the solution to today’s crisis, not the cause as they were during the global financial crisis. Governments and central banks around the globe are using banking systems as a conduit for their economic and monetary policies, implementing a wide variety of measures to incentivize banks to keep lending. In return, governments will continue to be highly incentivized to provide massive amounts of liquidity and support to lenders in order to see their economies through the current crisis.
This material reflects the views of the authors as of December 8, 2020 and is provided for informational or educational purposes only. Source(s) of data (unless otherwise noted): PGIM Fixed Income.
1European Central Bank, Euro Area Banking Sector Resilient to Stress Caused by Coronavirus, ECB Analysis Shows. July 28, 2020. (https://bit.ly/35VbMVr)
James Hyde
James Hyde is a Principal and credit analyst on PGIM Fixed Income's European Investment Grade Credit Research team, based in London. Mr. Hyde covers European banks. Mr. Hyde has more than 25 years of experience analyzing banks and other financials at European Credit Management, at Moody's Investors Services and as an equities sell-side bank analyst at Merrill Lynch and at Fox-Pitt Kelton. Since January 2018, Mr. Hyde has been selected to be a member of the Capital Markets Advisory Committee of the International Accounting Standards Board (IASB). Immediately prior to joining the Team at PGIM in 2010, Mr. Hyde worked at the Financial Services Authority, the UK regulator as a specialist on asset management regulation. Mr. Hyde received his BA in Economics from Manchester University and has an MBA with a banking specialization from Manchester Business School.
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