European banks’ financial fundamentals

FILE – The Euro sculpture stands in front of the European Central Bank, right, in Frankfurt, Germany, in this Dec.16, 2011 file photo. The European Central Bank took bold steps Thursday June 5, 2014 to protect Europe’s fragile economic recovery, cutting interest rates and offering to pump more money into the financial system. (AP Photo/Michael Probst, File)

“Following a decade of almost uninterrupted improvement, European banks display solid prudential metrics, good liquidity, and reasonable asset quality. But earnings remain weak at what could be the peak of their recovery,” Marco Troiano, deputy head of the financial institutions team at Scope Ratings GmbH, said in a report. “But we believe the decade-long build-up in capital ratios has come to an end, and banks will now have to think strategically about excess capital allocation against a backdrop of still-limited demand for credit.”

Troiano points out that some banks will need to retain earnings to meet regulatory RWA inflation; some may use earnings to speed up balance sheet cleanup; others will keep them as dry powder to finance M&A to achieve cost efficiencies or improve their competitive positioning in domestic markets. Current equity valuations imply that most European banks are value-destroying operations, which makes capital return an appealing equity story – and shareholders will increasingly demand higher payouts in the form of dividends or buy-backs.

“Crucially, a gradual increase in capital payouts is not necessarily bad news for bank credit because it demonstrates confidence on the part of regulators that buffers are sufficient. It also vindicates the theory that following the great re-regulation of this decade, banking should increasingly be seen as a utility-like, low-risk and low-but-stable-return sector,” Troiano said.

Scope believes the debate around bank profitability is badly framed, influenced by outdated anchors and expectations of double-digit profitability, which will remain out of reach for most banks in the current interest-rate and regulatory environment.

“The current median ROE for European banks of around 7% may be as good as it gets for the sector post-crisis,” Troiano added.

Cost of risk, the main cyclical driver for bank profitability, is at a historical low and is likely to tick up in core Europe and the UK. Meanwhile, all the structural drivers for lower profitability (expensive excess liquidity, flat yield curves, high capital requirements, over-capacity and outdated distribution models) are unlikely to change drastically in the near future.

Scope expects asset quality improvements to continue in Euro Area peripheral countries. Italian banks still account for about a quarter of total NPLs in the Eurozone, but the gap to other countries’ banks in terms of NPL ratios is declining fast. This trend should continue into 2020. These positive developments are likely to be offset by core Europe, however, where NPLs and provisions are likely to rise, albeit from very low levels. Even small changes in asset quality can have a significant effect on profitability of core EU banks, however.

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