Profitability in the banking sector has been under extremely heavy pressure since the crisis. Although an increase in non-performing loans and cost of risk, along with a decline in demand for credit are the usual components of a cyclical downturn in the banking sector, the surge in regulatory requirements and the extremely low interest-rate environment, with rates even turning negative, are a rather unfamiliar situation for European banks. After a challenging start to the year which saw sector valuations hit new lows, a number of more positive elements are currently arising. More positive factors for the sector include a series of measure designed at hastening the reduction of non-performing loans weight, coupled with the beginnings of consolidation in certain countries and a forthcoming base rate hike by the Fed leading to a steepening of the yield curve. Furthermore, regulatory pressure has also diminished somehow.
Since the end of 2008, the banking sector has significantly underperformed the broader European indices, except in 2012-2013 when banking stocks outperformed sharply. These two years correspond to a phase of increased profitability in the sector which was attributable partly to the cost of risk starting to decline and also due to a reduction in financing costs after the systemic stress during the summer of 2011. As profitability was starting to return to normal and valuations were extremely low, we heavily overweighted the sector in our portfolios from 2012 until mid-2014. However, the steep decline in long-term rates since 2014, towards unprecedented levels close to zero for 10-year German bonds, put heavy pressure on banks’ net interest margins. The progressive economic recovery-driven increase in credit volumes in Europe over the past few quarters has not been sufficient dynamic to offset the pressure on margins which undermined the improvement in profitability underway since 2012. This negative factor could be mitigated however over the next few months. Although the ECB is unlikely to modify its expansionist monetary policy in the short term, we think that European long-term rates should nonetheless steepen in the wake of intervention by the Fed. The US central bank should hike base rates further in the near term, given the strength of the domestic economy and amid increasing inflationary signs. The ensuing likely increase in US long-term rates should have a knock-on effect, causing European long-term rates to rise from their current all-time lows.
A more rapid reduction in the weight of non-performing loans on banks’ balance sheets constitutes a further positive element for the sector, particularly for Italian banks, which represent a proportion of our banking positions. The recently created Atlante fund in Italy will effectively underwrite the recapitalisation of the most distressed banks and will help streamline their balance sheets by acquiring non-performing loans.
The review of Italian insolvency laws also illustrates the political will to accelerate the restructuring process, in order to enhance the health of the sector which is vital to an economic recovery. In that respect, the announced merger between Banco Popolare and BPM constitutes a revolution among Italian Popolare banks, a reform, which has been under debate way before the crisis and was finally adopted last year. This was a considerable success for the Italian government which is now seeking further consolidation within the Italian banking sector still too fragmented.
More stringent regulatory requirements since 2008 have also been a major source of pressure on profitability in the sector, by requiring significantly increased regulatory capital quality and minimum levels. The sector now seems to be entering the last phase of regulatory changes. The Basel Committee publishes a consultative document proposing a new framework governing the use of risk weighted assets (RWA) as the denominator for banks’ solvency ratio. The Basel Committee should complete its RWA review, mainly covering credit risk, by the end of the year. The proposals seek to harmonise banks’ results and therefore make the data more reliable. The Committee has reiterated that these proposals should not lead to a significant increase in regulatory capital requirements. Certain local regulators such as the French banking authority have confirmed this view hence reinforcing the impression that although some regulatory changes are still due over the next few months, most of the efforts in terms of regulatory capital requirements have now already been made.
The European banking sector hit a new valuation low in the wake of the equity market decline since the beginning of the year. Many positive signals are now discernible however and should enable profitability in the sector to start returning to normal levels, leading to a significant outperformance as in 2012-2013.which led to a significant outperformance during this period.