A Selective Focus is Key to Navigating European Banking Sector Challenges

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1 A Selective Focus is Key to Navigating European Banking Sector Challenges March 2016 PERSPECTIVES Key Insights Andrea Brasili Senior Economist Global Asset Allocation Research Diego Franzin Head of Equities Europe Cosimo Marasciulo Head of Government Bonds Europe Edited by Giuseppina Marinotti Financial Communication Specialist Claudia Bertino Head of Financial Communication Financial stocks strongly contributed to the negative performance of the European equity market in early The underperformance of banks, insurance and financial services industries, relative to the broader market, has been substantial. In this piece we try to highlight where market concerns are coming from, what has changed for the financial sector since the 2008 crisis, what has improved and where the vulnerabilities are. We consider the evolution of the institutional framework and the risks that this process brings. We focus briefly on Italian Banks, and the initiatives to address their NPL (Non-Performing Loan) exposure, which are headed in the right direction but will take time to be finalized and implemented. From a macro perspective, the environment in which European Banks operate has been strongly impacted by Quantitative Easing, which has clearly helped banks repair their balance sheets. Banks have built higher and better-quality capital buffers, reduced leverage and improved funding profiles. At the same time, lower interest rates and, to an even greater degree, the adoption of negative deposit rates have squeezed interest margins and eroded bank earnings. Deflationary forces coming from the slowdown in China, the plunge in oil prices, and fears around the devaluation of the renminbi have exacerbated the stresses on banks. European banks now need growth and inflation to open profitable lines of business and to absorb NPLs, a legacy of the past crisis, and which are particularly high for Italian banks. Regional fragmentation of the sector is a concern and the institutional framework of the Euro system is still incomplete and fragile. Efforts are pointing in the right direction, but there is still much to do and hurdles to overcome. New regulations take time to be implemented; the issues facing European banks may take years before being resolved. In the face of ongoing problems, our stance on European Equities has been generally cautious on the banking sector but constructive for high quality institutions. In particular, we prefer banks with a proven business model, sufficient level of capital and sound funding structure, as we find that the current environment is much more difficult for banks that are still in the middle of heavy restructuring. Bottom-up selection is crucial in this environment, where exploiting relative value opportunities may be the key to portfolio returns. In Fixed Income, our cautious view on the sector is reflected in a conservative approach, particularly with respect to peripheral bond markets due to the link between banks and sovereign bonds, which is especially strong in Italy. Selectivity is the name of the game for the credit sector, where avoiding idiosyncratic risks will be key. Carry/roll at the short end still makes investment grade corporates attractive versus the cash or Government bond alternatives. Risk assets have had a very volatile start to the year. After the wave of selling, driven by the plunge in oil prices and concerns about China and global recession, additional turmoil has impacted the European banking sector. The weakening in sentiment around financial stocks and bonds has contributed to dragging down all risk assets. Deteriorating confidence in peripheral European banks has started to affect peripheral sovereign bonds, which had been the major beneficiaries of QE and yield hunting. 1

2 Europe Financial Sector Under Pressure The underperformance of financial stocks and bonds has sent a wake-up call that can hardly be ignored. Spread in bps CDS Financials Subordinated CDS Financials Senior Source: Bloomberg, data as of February 23, CDS or Credit Default is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a loan default or other credit event. The rebound in risk assets after reassuring comments from central banks has been strong, but the wake-up call can hardly be ignored. Are there risks of financial instability in the European banking sector which may become systemic? What has changed in the sector since 2008? How can investors navigate the current challenges? European Banks are operating today on stronger foundations than before the Great Financial Crisis. Firmer Bank Foundations European Banks are operating today on stronger foundations than before the Great Financial Crisis. Capital positions have improved substantially through new capital injections, asset sales and restructuring. Regulatory Tier 1 Capital to Risk-Weighted Assets 18% 16% 14% 12% 10% 8% 6% Germany United Kingdom France Italy Spain Source: IMF, Financial Soundness Indicators, data as February 23, 2016 Funding structures have become more balanced, with less reliance on debt. Financial leverage has declined, as reflected in loan-to-deposit ratios. Liquidity accessed through European central bank facilities has been mostly repaid. 2

3 Euro-Area Banks Leverage Ratio Total Assets / Equity Capital (%) 26% 24% 22% 20% 18% 16% 14% 12% Increased regulation and stricter compliance rules are imposing a different cost structure and making the old business models less profitable. The new world of low interest rates has created hurdles for bank earnings. Sources: ECB, Pioneer Investments, Data as of February 29, A More Challenging Landscape At the same time, the increased regulation and stricter compliance rules are imposing a different cost structure and making the old business models less profitable. As a consequence of new regulations, some of the risks have been transferred from banks to final investors, creating the potential for economic and social instability. Liquidity issues in corporate markets have emerged, as tighter risk management or regulatory constraints have limited banks market-making activities. Changing regulation (and often confusion around new regulations) has been a hurdle per se, as recent events in the AT1 1 bond market show. As the new guidelines for this class of flexible bonds increased the risks of coupon deferrals, prices declined in the absence of secondary market buyers; forced hedging contributed to a decline in CDS and stock prices. More clarity on the regulatory side will be helpful to avoid unnecessary loss of confidence in the sector. The new world of low interest rates has created hurdles for bank earnings, eroding opportunities in previously profitable businesses, such as money markets and fixed income trading, while the negative deposit rates set by European central banks have squeezed bank interest margins. What were meant to be exceptional and temporary measures with respect to unconventional monetary policies are becoming the norm, so banks need to quickly adapt their business models to a different interest rate environment. Regional fragmentation is very high in the sector, and exacerbated by the new regulations which prevent public intervention before bail-in 2. Recent idiosyncratic events in the European periphery the resolution of a few small Italian banks, the bail-in of certain Novo Banco senior unsecured bonds have led to a deterioration of sentiment with respect to the banking sector. 1 AT1 bonds: Additional Tier One Bonds are a class of bonds which are part of a bank s capital ratio. They have the ability to suspend coupons and convert into equity should a bank s capital position deteriorate sharply. 2 Bail-in: a bank s resolution regime where regulators can impose losses to specific classes of bondholders and depositors, recapitalizing the bank from within, using private capital, rather than through the injection of external capital (bail-out) 3

4 Redenomination risk is still perceived as high. Redenomination risk is still perceived as high. TARGET2 3 balances reveal that German banks prefer to maintain liquidity with the ECB, paying negative rate deposits rather than lending to Italian or Spanish banks at positive rates. EMU: Net Claims of National Central Banks Within Eurosystem (Target Balances) Billions Euro Germany Ireland Portugal France Italy Spain Bank risk sharing which sets the framework for crisis management which was the original rationale for Banking Union - is still incomplete. The deposit insurance function is the major missing piece of the puzzle. Source: Bloomberg, Data as of February 23, A Fragile Institutional Framework The institutional construct in which banks operate is still incomplete, and the integrated banking system, which could help smooth the fragmentation of the sector and give stability to the whole system, is far from being completed. With the Single Supervisory Mechanism (SSM) now fully implemented, and the January 1, 2016 introduction of the Bank Recovery and Resolution Directive (BRRD), a harmonized and predictable framework for regulation and supervision which can help prevent crises is in place. But the bank risk-sharing which sets the framework for crisis management and which was the original rationale for the Banking Union - is still very incomplete 4. In particular, there is still one major piece of the puzzle missing: deposit insurance at the euro-area level, which would integrate current deposit insurance schemes at a national level. With that function in place, depositors would be in a position to consider any bank as their home bank, thus reducing the sources of instability. Among the other open issues is the lack of clarity regarding the divide between bail-in and bail-out (and how it will be eventually funded). Also, importantly, there is the potentially dangerous sovereign bank feedback loop, as bank balance sheets contain large holdings of their own government s bonds. The EU Commission proposal of November 2015 moves in the direction of a fully operational European insurance, but very gradually (the fund, named EDIS, will be fully funded in 2024). Despite this gradualism, the proposal met with opposition from German authorities. The principal objection raised to eventual full risk sharing at the Eurozone level was the failure to address the bank-sovereign nexus. Indeed, they proposed that domestic bonds in excess of 25% of tier 1 capital should be weighted at 70%. This would raise serious issues for peripheral banks, particularly in Italy, where 3 TARGET2 is an interbank payment system for the real-time processing of cross-border transfers throughout the European Union. It is owned and operated by the Eurosystem. 4 See Firmer foundation for a stronger European Banking Union, Dirk Shoenmaker, Bruegel WP, November

5 the bank asset share of sovereign bonds is the highest. This unresolved issue clearly adds to the uncertainty surrounding the institutional setting in which banks operate. The issue of accumulation of bad loans by banks is particularly acute in Italy. The Italian Bad Bank: Where Do We Stand? An additional concern relates to the accumulation of bad loans by banks, a legacy of the crisis which impacted the European periphery with particular severity. Non-performing Loans to Total Gross Loans 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Italy Spain France Germany United Kingdom Source: IMF, Financial Soundness Indicators, data as February 23, 2016 The problem, which also involves Greece, Portugal, Ireland, and some German and Spanish banks, is especially acute and widespread in Italy. Total Italian NPLs amount to c. 350bn / 18% of total loans, and the worst element (Sofferenze) account for approx 206bn. Banks have c. 60% coverage / provisions against the Sofferenze exposures, but there is still a gap vs market prices, which is difficult to quantify as there is little transparency on executed deals and prices vary greatly depending on the kind of loans and collateral. Therefore further capital may be required to bridge the difference and to clean up the balance sheets. The new Italian banking legislation goes in the right direction, but many details remain unclear and implementation may take time. The Italian government just approved some new legislation on the banking sector, introducing new rules for large cooperative banks and on bankruptcy-related sales of real estate. Most importantly, the new law outlines the new guarantee scheme for securitized NPLs. However, this was a compromise, reached at the end of a very long negotiation with the EU Commission, which originally aimed to establish a bad bank at the national level to facilitate an accelerated clean-up of bank balance sheets as has been done in other jurisdictions. The new law suggests that each bank can set up a Special Purpose Vehicle (SPV) to which NPLs may be sold in order to securitize and sell the loans. A public guarantee for the senior tranches could be obtained, under certain conditions, with the payment of a fee set at the market price for credit insurance. This is designed to result in many small bad banks, as state aid regulation would no longer permit the creation of one big, partly publicly subsidized bad bank. The bad bank is not a panacea but it has some positive aspects. The speeding up of bankruptcy procedures and the linked reform of civil justice in Italy should reduce, in the medium term, the Loss Given Default ratio of Italian NPLs. A quicker and smoother disposal of collateral could also support the development of a bigger and more efficient market for NPLs. Potentially, the state guarantee could help further stimulate securitization of portions of NPL portfolios, but this will take time. 5

6 We expect the efforts of the different institutions to address both idiosyncratic and systemic liquidity issues will continue. On the negative side, there are a lot of details that remain unclear, first and foremost the price of the guarantee itself. The EU commission stated that the new Italian law does not breach the state aid rule, in as much as the guarantee is remunerated at market price. But there is still an overly wide bid-ask spread in the market for distressed loans; besides, if the price of the guarantee is too high banks could choose to retain their NPLs instead of suffering losses. What s Next? We expect that the efforts of the different institutions to address both idiosyncratic and systemic liquidity issues will continue. The ECB may provide liquidity by further expanding its balance sheet, prolonging QE, introducing new refinancing operations or widening the asset purchase program, perhaps in some way targeting support to peripheral markets. After the inclusion of quasi-agency bonds, an additional step could be to widen the asset purchase programme to include senior corporates, with the aim of reducing spreads and alleviating bank funding pressures. In Italy, while we continue to await the finer technical details of the new bad bank plan, we think the movement is in the right direction. Together with new bankruptcy reforms, secondary liquidity in the NPL market should help reduce the bid-to-offer gaps. However, banks may still be required to increase provision levels in coming periods to boost coverage ratios and therefore earnings and capital generation are likely to remain depressed. More importantly, with each bank needing to create and find funding for its NPL SPV, the solution will hardly be systemic and will likely take quite some time to be finalised. Lastly, lower interest rates for longer, due to the ECB s QE3 and a stalling growth outlook, will most likely cause NPLs to continue growing and bank earnings to suffer, therefore compounding the concerns around the broader sector. In the face of these ongoing challenges, from an equity perspective, our stance has been to focus on higher quality banks exposed to core markets. In the face of these ongoing challenges our stance, from an equity perspective, has been to focus on higher quality banks which we believe have the balance sheets to withstand these sector issues. In particular, we prefer banks with proven business models, sufficient levels of capital and sound funding structures, as we find that the current environment is much more difficult for banks that are still in the middle of heavy restructuring. We focus on banks which have access to better wholesale funding and, as a result, experience less margin pressure. We believe that bottom up selection is crucial in this environment, where portfolio returns may be driven by relative value opportunities and by limiting overall portfolio risk. In fixed income, we are cautious on peripheral sovereign bonds and very selective in the credit markets. On the fixed income side, we are cautious on peripheral sovereign bonds, given the tight link between banks and sovereign bonds, especially in Italy. Other elements supporting a defensive approach include increased geopolitical risks surrounding the EU less political cohesion, Merkel s weakened position, scrutiny of the Schengen, flows and valuations. A very selective approach is also important, in our view, with respect to the credit markets, where avoiding idiosyncratic risks will be key. The sector may come under pressure, as yields are generally low and there is little protection from duration in case of spread widening. Carry/roll at the short end still makes investment grade corporates attractive versus the cash or Government bond alternatives. 6

7 Important Information Unless otherwise stated, all information contained in this document is from Pioneer Investments and is as of February 29, The views expressed regarding market and economic trends are those of the author and not necessarily Pioneer Investments, and are subject to change at any time based on market and other conditions and there can be no assurances that countries, markets or sectors will perform as expected. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading on behalf of any Pioneer Investments product. There is no guarantee that market forecasts discussed will be realized or that these trends will continue. Investments involve certain risks, including political and currency risks. Investment return and principal value may go down as well as up and could result in the loss of all capital invested. This material does not constitute an offer to buy or a solicitation to sell any units of any investment fund or any services. All investments involve risks. You should consider your financial needs, goals, and risk tolerance before making any investment decisions Pioneer Investments is a trading name of the Pioneer Global Asset Management S.p.A. group of companies. Date of First Use: March 1, Follow us on: 7 REF-68