Given the economic shut down, bank investors are correctly weighing the scale of loan loss provisions in 2020. This is the dominant driver for bank earnings this year, but this focus obscures from view other positive earnings catalysts and developments that can act to support European bank share prices as we move toward 2021. In this note we discuss some of these supportive factors for banks that are tangible this year and next.
Last week the ECB announced the take up of TLTRO3, their latest Targeted Long Term Refinancing Operation. The total take up was €1.31 trillion with a net increase of approximately €550bn. The new terms are considerably more generous than in the past with banks being able to borrow this money, with certain conditions at -1%. The term of the TLTRO is 3 years. The -1% borrowing rate is available for the first year from 24 June 2020 to 23 June 2021, beyond that time the borrowing rate is set at -0.5%.
In previous TLTRO operations announced last year the best possible borrowing rate available was -0.5%. We anticipate that a large proportion of the latest €1.3 trillion in borrowing will be available at the -1% rate. Assuming just a 0.5% spread, i.e. a reinvestment at the ECB deposit rate of -0.5%, provides the potential to lift sector earnings by €6.5bn year-on-year. If banks choose to lend or invest this money at higher yields the profit potential is much larger.
The ECB has also reduced the interest rate banks have to pay to deposit money back at the central bank. In September 2019 the ECB introduced a tiering system whereby a proportion of bank deposits at the ECB would not need to pay negative rates. Previously all bank deposits above a minimum reserve were forced to pay the deposit rate. Today banks can deposit 6x their minimum reserves at a zero interest rate. There is currently €270bn at the ECB of which the majority is now paying zero in interest. The average system balance on ECB deposits up to September 2019 was €600bn, reducing bank earnings by €1.5-2bn Euros last year. That headwind to earnings is largely removed in 2020.
An unknown this year is whether net loan growth will be positive or negative. The scale of state guarantees available is incentivising credit creation, despite the fears around the economy. Whilst the fees and interest rates on state guaranteed loans are low, recent bank commentary suggests loan growth could well be positive, potentially significantly so, in certain categories. Positive loan growth can act as another support for earnings in 2020.
One of the little reported developments in 2020 has been the pick up in Euribor. Many European floating rate loans are indexed to Euribor. Whilst the increase in Euribor is small, it adds weight to the argument that the drag from interest rate declines is coming to an end. Similarly, the failure of German bund yields to fall sustainably lower than the lows of 2019 is a further indication that interest rates in Europe are bottoming out. This is yet to become an outright positive earnings catalyst, but the reduction in the drag of earnings from lower rates can enable banks to retain efficiency and cost savings more easily.
In recent years efficiency savings have been swamped not only by the reduction in net interest margins but also by regulatory capital inflation. This headwind is also coming to an end. One of the last pieces of the regulatory puzzle has been the capital build-up required under MREL (the minimum amount of equity and debt required to allow for an effective bank resolution). Nearly all large European banks have completed this process. Going forward there is no material change in the capital stack required by regulators. There are some changes to mortgage risk weights later on this decade that are impactful for Scandinavian and Dutch banks, but these are well known and provided for.
This is the first time in over a decade that banks are facing a static situation with regard to regulatory capital. This will open the door to more share buy-backs and higher dividends in 2021. European banks were just beginning to ramp-up dividends and consider buy-backs before this crisis. These shareholder friendly actions will resume once loan loss provisions subside next year. Share buy-backs have the potential to meaningfully increase EPS on a recurring basis. With PE ratios for the sector set to be 4-6x in 2022, investors can anticipate possible buy-backs of 5-10% per year, starting in 2021.
European banking M&A continues despite the crisis and ought to accelerate next year. Intesa is looking to complete their attempt to purchase UBI this summer. The ECB banking supervisor Andrea Enria continues to support and promote mergers. The ECB is considering incentivising M&A further with more favourable accounting treatment for negative goodwill. Spain and Italy are the most likely areas for in-market consolidation, but other large deals are possible.
Finally, we await the news around the European Recovery Fund. Whilst the details are still to be clarified, there appears agreement that the fund will be backed by commonly issued bonds by the European Commission. This is an enormous step toward fiscal union, directly addressing the central bear case held by many investors about the European project. Italian BTP spreads ought to narrow further verses bunds and the Euro currency itself ought to be underpinned. European banks have faced a higher equity risk premium due to the perceived structural weakness of the Euro. An agreement on the European Recovery Fund should reduce this equity risk premium and lift the multiple of the European banks sector on a structural basis.
Whilst the short term macro is clearly important, once this current crisis subsides, a wide variety of positive catalysts for European banks will become visible. Short term, TLTRO3 and ECB deposit tiering can support earnings by close to €10bn over 2019. More importantly, the structural headwinds from declining rates and regulatory capital inflation are over. This summer, a step forward for European solidarity and fiscal integration can help to lift the sector multiple. Investors should anticipate significant increases in buy-backs, dividends and M&A from 2021. At 40% of book value, the European banks sector is offering a compelling long term entry point.
Sources: ECB, Lightman, Bloomberg, June 2020
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