Which Banks Are Solid Investments in This Volatile Market?

 |  Includes: BAC, C, HSBC
by: Alicia Damley, CFA

The democratic quest of nations in the southern Mediterranean basin has taken a less than desired turn. In addition to the risks for global oil supplies and prices, increasing bloodshed risks destabilizing global economic growth. What began as the world cheering the exercise of mostly peaceful demands for autocratic regime change has most recently deteriorated into the ignition of deadly civil wars, increasing the need for external intervention. Geopolitical risk continues to edge higher accompanied by market volatility.

The strife in the Middle East North Africa [MENA] region has had limited (relative) negative impact on the global banking system mainly because of limited direct exposure of foreign banks to the region. Banks with the largest exposure (including Société Générale, Crédit Agricole, UniCredit and Intesa-San Paolo) are typically those from countries with historic ties.

Even before the MENA backdrop, the bank sector was already experiencing a number of headwinds. Fiscal year end reporting is beginning to reveal the secular decline in RoEs (see here). While regulatory reviews are now mostly completed, Basel III guidelines begin to come into force (see here).

The European banking sector continues to face numerous challenges. The next round of bank stress tests will be underway shortly. Given the poorly disguised, feel-good attempt of last year and the market’s tepid reaction, this year’s tests must be more robust.

A year on, the EU bank sector is still blanketed by the sovereign debt crisis, wholesale funding overhang and incomplete capital-raising. Hopes for a resolution of the sovereign debt crisis continue to elude the political elite. Contagion risk is high. Domestic bank sectors in Spain, Germany and even Italy need restructuring. Capital levels are the lowest amongst peers. With these headwinds, the sector should arguably be avoided as a whole. However, some names such as Hong Kong Shanghai Banking Corp. (HBC) stand out for their global footprint, particularly in fast-growing emerging markets, and strong balance sheets.

Broadly, the banks that continue to be sheltered from many of these headwinds are in emerging markets. Focused primarily on their domestic markets, these banks weathered the recent global financial crisis particularly well under sound guidance of their regulators and management. Loan demand has continued on trend, and credit risk remains under control. Unlike the developed world, rising inflation and interest rates raises the risk of spread compression, but these are not new concerns, and banks with top franchises have managements seasoned in this task. Some of the names to consider in this space are Bank Credit Asia, Bank Rakyat, Credicorp, State Bank of India and Axis Bank. The recent de-rating of EM bank stocks (see here) provides an attractive entry point.

Following substantial infusion of public funds, US banks have come through the crisis, which for many, was self-inflicted. Since then, balance sheets have been restructured, toxic assets sold or carved out, bailout funds returned, equity capital raised and rounds of cost-cutting undertaken. Loan growth has been expectedly weak, but is showing signs of resuscitation. Credit risk continues to remain benign, comfort that lending provisions have proven adequate and the economic path sufficient to deter new risk. Many of the large US banks currently boast some of the highest core Tier 1 ratios, reassuring in the current environment. Some names offering value include Citigroup (NYSE:C) and Bank of America (NYSE:BAC), though each suffers from near-term concerns.

The global banking sector has staged a strong recovery from its dismal position less than three years ago. In many respects, it has come together successfully. In the Middle East, what began as people exercising their right to free speech and demanding positive change has clearly deteriorated. Global support has increased as has investment risk. However, opportunities to invest still exist.

Disclosure: I am long BAP, C, HBC.A.

Additional disclosure: Long Bank Central Asia