I receive a note from Berenberg’s banks analysts offering feedback from meetings with 90 US and European investors and reporting a shift in sentiment towards European banks.
The research says that many generalist investors suddenly want to own European bank shares for the first time in many years.
These investors are coming round to the view that their net interest margins will improve more than previously hoped and that loan losses will stay low, allowing banks to generate “acceptable returns” as assets reprice and deposit hedges are re-invested at higher yields.
“Staple holdings of US banks among US investors are losing their luster in favour of European banks,” Berenberg suggests. “This reflects a reversal of historically stronger US growth (versus Europe) and a premature exhaustion of interest rate benefits for US banks.”
The report lands at an intriguing moment as European banks continue to lobby for lighter capital regulation, saying that stricter European rules have made their returns on equity uncompetitive next to large US rivals, whose shares trade at premiums to book value whereas many European banks for now still trade at discounts, sometimes substantial ones.
European banks continue to lobby for lighter capital regulation, saying that stricter European rules have made their returns on equity uncompetitive next to large US rivals
The argument has been rumbling for 15 years. European banks say they are being penalized for running large balance sheets of low-risk assets such as residential mortgages, which US banks can easily offload into a securitization market supported by the government sponsored entities, Fannie and Freddie.
Europe doesn’t have such a market.
However, European regulators long ago became suspicious that some banks may have been gaming their internal risk models and so have looked to set new floors.
When Deutsche Bank reported full year 2022 results at the start of February, chief executive Christian Sewing told analysts: “I am a bit disappointed about the regulatory environment we see in Europe.” He says that while regulators are right to focus on safety and soundness, “we also need to remain competitive.”
Sewing struck a more forthright tone in his speech to the European Banking Congress last November, when he said: “We urgently need to change course here if we do not want to rely primarily on foreign banks to finance Europe's future.”
Sewing launched a call to “recalibrate regulation in Europe”, warning about the inhibition of lending to support the green transition from potentially higher capital requirements through Basel III reforms as well as restrictions on leveraged finance.
Economic impact
More recently, the European Banking Federation (EBF) commissioned a report from Oliver Wyman on the impact of banking regulation on the EU economy.
Published at the end of January, this argues that because the EU market remains fragmented, the approach to determining bank capital requirements is more complex and less transparent than in the US, leading to uncertainty and banks retaining additional surplus capital.
Leading European banks tend to run with common equity tier 1 (CET1) around 15%, while large US banks are closer to 12%. European banks have liquidity coverage ratios at around 160% compared to 120% at US peers.
Oliver Wyman suggests that the incremental difference in regulatory-induced cost at EU banks compared to US peers can explain up to one percentage point of the difference between their reported returns on equity.
That’s not very much, given that the biggest US banks deliver RoEs in the mid-teens compared to high single digits at many European lenders. But the peer groups are not directly comparable. The big six US banks operate on a completely different scale to Europe’s 20 or so smaller national champions.
So, Oliver Wyman also conjures up the notion that a review of current capital requirements and regulatory processes could – hypothetically – free up another €4-4.5 trillion of bank lending to support the drive to a more sustainable and digital EU economy.
The EBF, endorsing the report, calls on policymakers to foster a European securitization market that right now, even when combined with the UK’s, is still 17 times smaller than that of the US. The EBF also says that “as Basel III is fully implemented, authorities must ensure that EU banks do not have a disadvantage on the global playing field.”
Weaker profitability
European regulators have not helped their credibility by urging consolidation as the answer to European banks’ weaker profitability.
That’s unlikely to happen when the EU is still made up of separate sovereign states with their own bankruptcy codes and banking product designs whose politicians want strong and dedicated local banks. Shareholders see limited cost saving benefits from cross-border acquisitions – last in vogue during the run-up to the great financial crisis – but plenty of risk.
Merge two medium-sized moderately profitable European banks and, even if you manage through all the execution risk and opportunity cost in senior executives’ time and attention, you’ll likely end up with one large moderately profitable bank.
And there could be good reasons that explain weaker European bank profitability rather than under-leverage.
Merge two medium-sized moderately profitable European banks and... you’ll likely end up with one large moderately profitable bank
Sam Theodore, senior consultant at Scope Group, points to US banks’ greater discretion to avoid unprofitable customers in a country where a much higher percentage of the population remains unbanked. Banking penetration is around 95% in Europe, where banks serve larger numbers of unprofitable customers. They also hold large volumes of low-risk but low-return mortgages to maturity, funded through covered bonds: not a particularly profitable business but a useful one for society.
Cutting back capital requirements is not a good look for regulators, even though European banks have demonstrated their soundness through the more recent troubles.
Maybe they have only done so because of strict regulation and high capital and perhaps relaxing now would drain confidence from those very investors that, Berenberg says, having avoided European banks stocks for years, now intend to pounce on the value.
Theodore, talking up the credit investor view, says: “This is not the moment to relax capital requirements. Only a couple of months ago economists were predicting a recession. A banking system with strong levels of capital and liquidity is a sine qua none.”
It would be some irony if calls to lighten up on regulation should scare investors away just when they are set to close the valuation gap between European and US lenders.
