Europe’s lenders have endured a painful decade waiting for interest rates to rise.
But with central banks finally moving, long-awaited income windfalls are under threat and cash-strapped governments fear new taxes on lenders.
Last week, the European Central Bank raised interest rates by half a percentage point to zero for the first hike since September 2011. It follows more aggressive hikes by the Federal Reserve and the Bank of England in an effort to control inflation, which is forecast to break into double digits soon.
“The world needs to relearn banking,” UBS chief executive Ralph Hammers told the Financial Times. “The eurozone has been in negative territory for eight years, Switzerland is now in negative territory for seven years, where people don’t value deposits, savings accounts.”
“The bankers who have been with us here in Switzerland for the past seven years have never worked for a bank in a positive rate environment,” he added.
The parallel developments of beneficial rate hikes and damaging consumer and corporate crises have divided opinion over how Europe’s banks have seen their earnings stagnate after a decade and their share prices have dramatically underperformed their US peers.
are on the rise for the first time in many years. Morgan Stanley analyst Magdalena Stoklosa hailed the rate hike as a “game changer” for the sector. A higher base rate means an improved net interest income (NII), which translates into a bank’s higher profitability as a measure of the difference between charges for deposits and loans.
“We think that eurozone rate hikes are … the biggest structural catalyst for European banks,” Stoklosa said. She predicts the “cheap” sector will “rise 52 percent” to its current depressed stock market valuation.
Those with large balance sheets and loan books stand to benefit the most. HSBC, for example, is sitting on a global deposit surplus of $700bn and estimates that a 1 percentage point jump in rates would generate an extra $5bn of NII annually – equivalent to a tenth of last year’s $50bn revenue.
Lloyds Bank estimates that a one percentage point base rate increase would add £675 million to earnings in the first year.
Rising rates and resulting market volatility are also good for investment banks. Barclays, BNP Paribas and Deutsche Bank have generated billions in revenue as client activity surges through their major trading arms.
On Thursday, Barclays said revenue from fixed income trading rose 71 percent to £1.5 billion in the second quarter. Similarly, Deutsche Bank reported a 32 percent quarterly increase and Goldman Sachs reported a 55 percent increase in the same trade earlier in the month.
“Whether you’re an asset manager or a corporate, a long sustained rate trend means you need to rebalance your portfolio more often, which has driven revenue in a meaningful way for us and the industry,” said Ram Nayak, co-head of investment banking. said Deutsch.
Such optimism from analysts and investors has not been seen in years. Hit by anemic profits, misconduct scandals and high capital requirements, major European and UK banks have traded below the book value of their assets. Few consistently return more than 10 percent on equity, which investors consider the minimum.
After the financial crisis, the sector was slow to restructure and has lagged far behind Wall Street in investment banking. A lack of cash to invest in technology has left banks vulnerable to competition from fintech start-ups and big technology companies like Apple, Google and Amazon.
However, the end of years of ultra-low or negative rates “neutralizes their core franchise from the possibility of incurring losses,” Bank of America analyst Alastair Ryan said. Based on current projections for further growth, BofA expects EU banks to generate a much-needed €17bn in NII earnings each quarter within a year.
Back to the 1970s?
But even as optimism grows, a big question remains unanswered: How much higher debt losses will eat into the interest rate environment. Consumers are facing a sharp cost of living crisis and small businesses are struggling with reduced spending and snowballing inflation following the global Covid-19 lockdown.
Some believe the region can cope, as it did during the worst of the pandemic.
“Even given the delayed loan, we expect the recurring revenue benefit of higher interest rates to significantly outweigh the one-time impact of higher provisions,” BofA’s Ryan said.
Others are less clever.
“The impact of regulation and bankruptcy is not easy to predict. The situation is like Covid; it’s completely new, we haven’t been through it since the 1970s,” said Jerome Legras, head of research at investment firm Axiom. .”
A portfolio manager at Capital Group led a €7 billion sell-off in European bank stocks this year as the region’s economy turned and lenders faced huge losses and rising costs due to inflation.
Economic and political risks – such as in Italy, where the resignation of Prime Minister Mario Draghi has sparked a crisis that has spilled over into government debt markets and the banking system – continue to mount.
“Recessions appear increasingly likely in both the US and Europe. . .[and]History tells us that earnings in the European banking sector typically fall by 50 percent,” said Stuart Graham, an autonomous analyst.
“The current sentiment is extremely weak,” he added. “Investors see a lot of things to worry about – mainly ‘Russia pulls off gas-driven recession’, but also 1970s inflation, bank taxes etc – and few if any positive catalysts.”
However, so far there is little evidence of customer distress and most of the tens of billions in Covid-related bad loan reserves are poised to absorb losses. European banks reporting second-quarter results beat most expectations despite warnings of financial pain to come.
“The most important indicator for banking asset quality is overall employment. We need to see how that plays out, but if the labor market holds up as economists expect, credit quality should remain resilient,” Santander executive chairman Ana Botin told the FT.
Barclays added no additional reserves to cover bad loans in the UK in the second quarter. Finance director Anna Cross told the FT that “customers are acting in very rational ways”, for example by paying back their credit card balances faster.
“We’re seeing a real build-up of savings and repayment of unsecured debt by consumers and corporates, so they’re going into this environment in much better shape than pre-pandemic,” he added.
Another UK bank executive said, “We haven’t seen any signs of stress in our portfolio. The earliest is typically an increase in people making minimum payments on credit cards, but while it’s increasing slightly, it’s not back to pre-pandemic levels.”
The BoE and ECB have already written to banks warning them not to be harsh with distressed customers and the industry is keen not to lose the goodwill it has generated during the Covid crisis.
There is also the possibility of more extraordinary government aid for those struggling – as was introduced during the pandemic – which would reduce the risk of banks failing.
“Maybe there will be subsidies to businesses struggling with the energy crisis, guaranteed loans, etc.,” Axiom Legras said. “I think the public sector response will be helpful for the banks.”
But there is widespread fear among bank executives that higher profits will lead to new charges. Spain has proposed a windfall tax of 4.8 percent on banks’ fees and interest charges, designed to recoup some of the benefits from higher rates.
The announcement wiped billions off the ratings of the country’s five biggest lenders, including Santander and BBVA. Hungary has taxed its banks while Poland has frozen mortgage payments to help struggling homeowners.
“Banks are easy targets and the prospect of more taxes is terrible for banks” [valuation] Multiplication,” said a hedge fund manager specializing in European financials. “Blaming big corporations is always a proven way in a recession to distract from the government’s own policy failures.”
French Finance Minister Bruno Le Maire told the FT in a recent interview that he has not ruled out windfall taxes next year and that “the burden of inflation must be shared equally between the state and business”.
The UK already has both a bank levy and a 3 per cent surcharge on bank profits, recently reduced from 8 per cent, but is at risk of being reset if the Treasury needs cash.
Regulators are also looking to cut another potential rate-related windfall.
The ECB is testing how it can prevent banks from making billions of euros more in profits from its €2.2tn subsidized lending scheme, which was launched to avoid a credit crunch during the pandemic. Some analysts estimated that lenders could earn a collective €24bn by depositing cheaper loans back into the central bank to benefit from the current higher rates than when issuing the loans.
But, while much debate continues about the profitability of the European financial system, few are concerned about its solution. Recent stress tests show that most lenders can withstand even extreme financial stress after being forced to build up adequate capital buffers after the 2008 crisis.
Some see avoiding another crisis as an opportunity for banks to shake off the persistent negativity around them.
“A ‘good recession’ could be a long-term positive for the sector,” Graham said. “If European banks can weather it with no worse than 25-50 percent hits to earnings, no major equity increases, no regulatory blanket restrictions on payments and limited banking and financial repression, it may finally relax some of the slack. Many investors are skeptical. “
“But that’s the good thing about European banks – you always have more things to worry about.”
Additional reporting by Owen Walker and Siddharth Venkataramakrishnan