As rates fall, European banks can still rise
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.
By Liam Proud
LONDON, July 22 (Reuters Breakingviews) -The bosses of Europe’s biggest banks are asking investors to believe two seemingly contradictory things: that while their earnings benefitted from rate hikes, rate cuts could be good for them too. It’s less implausible than it sounds.
Lenders like HSBC HSBA.L, 0005.HK and Intesa Sanpaolo ISP.MI did well when tighter monetary policy turbocharged returns. The 10 biggest members of the STOXX Europe 600 Banks Index .SX7P will this year generate a 13% average return on tangible equity, according to Breakingviews calculations based on analyst forecasts gathered by LSEG. That performance was unthinkable for much of the past decade, when low or negative interest rates kept returns well below the 10% bank investors generally require.
Even now, banks’ share prices aren’t behaving as if this good performance will last. Those 10 banks trade at slightly below forecast tangible book value, on average, suggesting that longer-term returns will fall below the cost of equity. In simple terms, the profit party that has buoyed bank bosses like Charlie Nunn of Lloyds Banking Group LLOY.L and UniCredit’s CRDI.MI Andrea Orcel will be short-lived.
The case for skepticism about European banks is pretty easy to make: the money came a little too easily last year. European banks have been able to invest zero-cost deposits at a handsome spread. Even ultra-safe two-year German debt has yielded close to 3% since early 2023, while money placed on reserve at the European Central Bank and Bank of England has paid about 4% and 5% respectively, compared with nothing in 2021. The result is a tonne of interest income that plumps up revenue. The 10 big banks are likely to make 213 billion euros of net interest income this year, according to Visible Alpha, or 36% more than in 2021.
As interest rates start to recede, it might seem like profit will too. Not according to bank bosses, who are generally still gunning for chunky double-digit returns this year and next. Ana Botín’s Banco Santander SAN.MC, for example, is targeting a 16% return this year and 15-17% in 2025. That implies a big gap between her expectations and those of the market, which values the Spanish lender below tangible book value – implying that its long-term returns might be in the single digits. Analysts are generally on the optimists’ side, forecasting roughly flat returns of around 13% for the 10 banks on average in the coming years, despite looser monetary policy.
There are some ways in which banks could indeed have it both ways. For one, rates may not fall as much as they rose. Central banks are cutting, but they’re not taking rates all the way down to zero – or less than zero, as was the ECB’s policy for many years. Investors reckon the key euro zone lending rate will stay comfortably above 2% by the end of next year, based on derivative prices crunched by LSEG, while the Bank of England’s equivalent should be just under 4%. That level will crimp the margin that Santander and others can earn on idle cash. But the spread will still be positive, and certainly larger than in the dark old days of negative euro zone rates.
Falling rates will even bring some outright benefits. Households and customers might be willing to borrow more, for example. That would allow Crédit Agricole CAGR.PA and its peers to make more hay from the gap between old existing loans and newly issued ones, which UBS analysts reckon is 1.8 percentage points in France for mortgages and 2.2 percentage points for consumer credit. It makes sense that for customers, falling prices create more demand. Amsterdam-based ING INGA.AS, for example, said at a recent investor event that its net interest income would increasingly depend on lending volumes rather than interest-rate margins.
Demand for another bank product – merger advice and underwriting stock and bond issues – ought to rise too. That’s particularly relevant for those with large investment-banking divisions like Barclays BARC.L and BNP Paribas BNPP.PA. Dealmaking and debt and equity underwriting generated about $23 billion of income last year in Europe, LSEG data shows, which was the lowest haul since 2016. That should go up as rates go down, allowing companies to borrow more for mergers and acquisitions and giving startups the confidence to go public. In the United States, JPMorgan JPM.N, Bank of America BAC.N and their peers all reported a huge jump in deal fees in the second quarter. Citigroup’s C.N haul rose by 63%, year-on-year. Morgan Stanley MS.N boss Ted Pick thinks that easing inflation and lower rates has created “the early stages of a multi-year investment banking-led cycle.”
Finally, lower rates should dampen one of the biggest risks for investors in European banks: borrowers being unable to pay. Annual bad-debt provisions for the 10 biggest European banks have stuck at around 30 billion euros overall in the past couple of years. That’s close to the pre-pandemic norm, despite one of the fastest interest-rate run-ups in history. Rate cuts could save households and firms that might otherwise fall into arrears, meaning smaller loan-loss charges for the banks.
Each bank has its own unique exposure to rates, on the way up and the way down. BNP’s net interest income, for example, is around two-fifths of overall revenue according to Visible Alpha data, while at BBVA BBVA.MC it’s roughly three-quarters. Southern European lenders historically have higher loan losses than Dutch ones. But the prevailing valuations suggest that investors are still too glum towards the sector, despite a near-20% rally this year. Perhaps that’s because they’ve been scarred by years of poor performance, or they’re expecting a hit from the region’s increasingly volatile and populist politics. There are plenty of challenges ahead for European banks, but a decline in interest rates is one they should be more than able to meet.
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CONTEXT NEWS
European lenders including BNP Paribas, Banco Santander, UniCredit and Deutsche Bank will report their half-year results on July 24.
The STOXX Europe 600 Banks Index rose by 19% between the start of 2024 and July 19, compared with a 6% increase for the wider STOXX Europe 600 Index.
Graphic: Big European banks' forecast return on tangible equity Big European banks' forecast return on tangible equity https://reut.rs/4cMySxM
Graphic: Banks' interest income soared even as loans stayed flat https://reut.rs/3ScfeTm
Graphic: Return on tangible equity forecasts for big European banks https://reut.rs/4bKtius
Graphic: Money-market prices imply gradual ECB rate cuts over time https://reut.rs/46dInU5
Graphic: Banks' bad-debt charges have stayed low despite rising rates Banks' bad-debt charges have stayed low despite rising rates https://reut.rs/3Sat2hu
Editing by John Foley and Sharon Lam
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