European banks: still waiting for Godot
22 May 2020 | Markets and Economy
Commentary by Samuel Lopez Briceno, senior analyst in Vanguard’s Fixed Income Group
In Samuel Beckett’s famous play Waiting for Godot, the main characters—Didi and Gogo—spend the whole time waiting, ultimately in vain, for someone called Godot to arrive. Some equity and bond investors might know how they feel, after waiting for more than a decade for European banks to fully recover from the previous crisis.
The saga for European banks started with the 2008 global financial crisis and was quickly followed by the 2009 European debt crisis. Both events were so significant that they not only surprised most investors but also highlighted the now well-known weaknesses of the banking sector. European banks were highly unprepared for any crisis, as they had been increasing their risk on both the asset and liability fronts. On the asset side, the relatively low interest rates and lenient regulatory controls (permitted by the prevalent Basel 2 agreement at that time), incentivised banks to increase their assets and risk to very high levels versus their equity levels. On the liability side, the system had become over-reliant on short-term debt instruments for funding.
These crises triggered the worst economic environment for European banks that most of us had ever seen until then. Given the unpreparedness of the banks themselves, the recovery period was bound to be long, especially given the ongoing structural issues in the sector. But many in the market still had an incipient hope that their Godot—a full recovery—would indeed arrive. However, nobody could have predicted that we would be hit by a global health crisis that has since turned into an economic crisis, with a likelihood of it ending up as a financial crisis.
Real-life stress test
The coronavirus crisis has presented us with a real-life adverse stress test scenario for European banks. Some banks are in fact better prepared this time around, but they are still vulnerable. Their structural issues (such as their high leverage relative to US banks, lack of consolidation and inadequate efficiency and profitability) have not been fully addressed. Nevertheless, the negative impact on banks’ balance sheets from this crisis is being offset in part by the extraordinary remedial actions rapidly taken by both governments and regulators.
Without the recently implemented fiscal measures (such as loan guarantees for companies), quantitative easing (QE) and regulatory forbearance (mainly in the form of capital relief), one can easily imagine that it might have been ‘game over’ for a significant part of the European banking system, as widespread nationalisation of banks would probably have been required. But thanks to the significant fiscal actions, forceful market intervention by the European Central Bank and remarkable regulatory forbearance, there is now a lifeline for European banks.
A question many investors are now asking is: Is this an opportunity to invest in European banks? But at Vanguard, under our active risk-adjusted framework, there is not a simple yes or no answer. That’s because we don’t believe that trying to simply time the market would be an adequate response. Rather, our investment process is anchored on both a thorough bottom-up fundamental assessment and a risk-adjusted relative-value approach. And there is another way investors in our fixed income index funds benefit from our approach, for while the Bloomberg Barclays Global Aggregate Bond Index comprises around 25,000 bonds, we don’t buy every single one of them. Our portfolio managers generate alpha by picking the bonds with the most favourable characteristics, based on discussions with our active analysts, all the while ensuring that the key risk factors of the benchmark—such as yield to maturity and duration—are matched.
Generating alpha by working with analysts in this way not only offsets trading costs, but also helps to avoid issuers that may exit the benchmark due to downgrades. It also helps our portfolio managers and traders to manage the liquidity profile of our funds. Moreover, while we don’t take active decisions on the equity index side, investors in our equity index funds also benefit from our fundamental analysis as both the counterparty risk and how much we can trade with specific banks depends on the quality of the banks’ balance sheets.
Challenges ahead for European banks
The six largest US banks have all released their first-quarter results. While their trading revenues appear encouraging, as market volatility and record credit issuance have been helpful tailwinds, total provisions against expected future loan losses add up to around $25 billion1 for these banks (equivalent to more than one quarter of their earnings). European banks have also started to report their first-quarter numbers but—with very few exceptions—provisions for loan losses are modest in contrast to US banks. This suggests that the worst could still be to come for European banks. And this could be the start of a more significant negative trend globally. Most recessions tend to produce cumulative loan losses equivalent to three-to-five quarters of earnings. In an especially deep recession, loan provisions could be as much as nine quarters of cumulative earnings losses (as seen in the US banks’ DFAST2 stress tests conducted in 2019).
The chart below shows how historical recessions have played out for a sample of global wholesale banks. It hints at what a deep recession could mean, not only in terms of lost earnings, but also the length and the consequent return on equity for the banks.
Characterising past recessions
Source: Oliver Wyman.
For the European banks we analyse, we have produced a hypothetical stress test that is harsher than the current situation but is in line with what we might see over the coming quarters (assuming government and regulatory actions are not fully effective). The outcome of this stress test, together with our qualitative fundamental considerations and the risk of rating downgrades, gave us a list of names and debt structures that are likely to withstand the crisis, credits to avoid and a watch list that we continue to monitor. As an additional layer of analysis, we assess individual investment opportunities, selecting names that we expect to outperform our benchmarks on a risk-adjusted excess return basis.
Like Beckett’s Didi and Gogo, many investors have thought several times since the GFC that the recovery of European banks was imminent, only to have their hopes dashed. This new crisis will bring European banks back under the spotlight, and probably not for the right reasons. However, we believe that while the short-term outlook for European banks is challenging, there are still ways that we can allow our investors to benefit, by selectively investing in the issuers and debt structures that are likely to withstand a severely adverse scenario of this crisis.
And even if the market continues to wait for Godot, hoping a turning point for European Banks eventually arrives—either driven by mergers and acquisitions or the long-awaited European Banking Union—we will continue to focus on opportunities that represent an adequate risk/return combination for our investors.
1 Source: Vanguard calculations.
2 Dodd-Frank Act Stress Tests.
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