The recent ascent of European bank valuations has been sharp. From a place a little more than a year ago, where the majority of banks were trading around half of book value, most now trade at small premiums, observes Matt Beesley, head of global equities at Henderson.
The cost of owning these banks – which combines the cost of borrowing to fund the position and the premium that investors should expect for the risk of holding it – Beesley estimates at about 10%. “But the prospects of these banks generating returns that exceed this cost of equity are several years off,” he says.
Many of the gains, which were particularly striking for banks in Italy, Spain and at Europe’s periphery in Portugal and Greece, happened last summer. This has helped to drive prices in a still-troubled sector up as quickly as the European equity average. For the last year Bloomberg’s index of European Banks has gained about 20%, almost exactly in line with the Bloomberg 500 (a broad European equity index).
The banks counter that they are well placed to reward investors’ faith. They predict a striking growth in earnings this year, in part boosted by a surge in lending to SMEs, as soon as the Asset Quality Review (AQR) is complete.
This latest – and most thorough – regulatory inspection of the balance sheets of Europe’s 130 largest banks will be conducted by the ECB, when it takes over full responsibility for supervising euro-area banks. The process, the ECB has assured markets, will be complete before this autumn.
The details of AQR will not be revealed by the ECB until the process is complete in case investors take flight from institutions they feel will perform badly. But banks are busy trimming their lending books to ensure that they present well on inspection day.
(Discussions between the ECB and the banks are progressing behind closed doors and a furious period of horse trading is underway, with the French keen to include sovereign and public debt in the review and Spanish keen to exclude it.)
After this hurdle is removed, banks argue, they will go on a lending spree. Half of the banks surveyed for EY’s January European Banking Barometer report say they expect to increase lending to SMEs over the next six months. This will drive an increase in overall performance, which 60% of respondent believe will materialise over the same period.
But Beesley is sceptical. In the first case, AQR is something of a smokescreen. Many banks already have their houses in order, following a slew of rights issues. Those that don’t still have plenty of time to get there: Beesley predicts the tests are likely to come as late in the year as possible.
The real impediment to SME lending is demand. This may be helped partly by the relaxation of covenants – more than half of respondents to the EY report anticipate that lending policies will become less restrictive. But the fact remains that, at current rates, SME’s aren’t confident enough in their economic prospects to take on new loans.
Even assuming demand for loans in this sector picks up – a big if – there will be no reason for large firms to follow suit. “Large corporates are sitting on large cash reserves so have little need for capital,” he says. If they do, today’s huge corporate bond market means that it’s “almost cheaper” for them to offer money this way.
What buying opportunities that remain in the sector are not for the faint-hearted. RBS, notes Beesley, is one of the few European banks that on February 26 still traded at a discount to the cost of its book. Investors who stayed away were relieved the following day, when it announced an £8 billion ($13.4 billion) loss for 2013.