A few months ago, I've analyzed the European banking sector landscape and how it was improving after several years of restructuring following the global financial crisis of 2008-09 and the Eurozone debt crisis. European banks are now much better capitalized and earnings are improving rapidly due to the economic recovery that is leading to much lower credit losses. After several years of balance sheet repair the investment case for European banks has now turned to shareholder remuneration, through higher dividend payments expected over the coming years.
However, European bank stocks have been quite weak over the past few weeks posting in some cases sharp corrections of over 30% since the beginning of the year. Several factors have contributed to this negative performance, namely the low oil price, low interest rates, doubts about credit quality in Italy, poor profitability of investment banks and the strength of banks' book values if credit quality deteriorates.
Additionally, legacy issues continue to negatively affect banks' profitability and average return on equity (ROE) continues to be below the cost of equity, meaning that banks do not generate enough earnings to compensate shareholders for the risks taken. This is one major issue regarding the European banking sector and that is leading to negative investor sentiment, especially considering that interest rates continue to decline and should continue to hurt banks' profitability for some time.
Commodities and Energy Exposures
One major issue that is making investors nervous regarding European banks is the exposure to the commodities and energy sector and possible loan losses coming from this area following sharp declines in commodity prices over the past few months that will eventually lead to defaults. Some investors are even worried that this may spark a new credit crisis and a recession in Europe. All these issues have increased investor worries about European bank credit quality and if capitalization levels are enough to withstand potential losses.
Even though disclosure levels of exposure across banks is not very transparent, European banks should have between $400-500 billion of exposure to the commodities and energy sectors representing on average around 4% of total loans. While this exposure does not seem too large, it may increase during the next few quarters if energy and materials companies use their undrawn credit lines with European banks, possibly leading to aggregate exposure increase of about $50-75 billion. Within the European sector the banks most exposed are Standard Chartered (OTCPK:SCBFF), DNB (OTCPK:DNHBY), Credit Agricole (OTCPK:CRARY), ING (NYSE:ING) and Societe Generale (OTCPK:SCGLY) with exposures ranging between $20-40 billion for each one.
Within the energy sector, credit risks associated with the oil & gas sector are not all the same with some segments more risky than others. Namely, Exploration & Production (E&P) and Offshore segments are usually considered to be most at risk. European banks are not much exposed to these segments, thus a large portion of oil-related exposures do not appear high risk, contrary to U.S. banks that are more exposed to E&P and Offshore. Moreover, most European banks are exposed to investment grade credits while in the U.S. exposure to high-yield is much higher, where defaults are much more likely. This suggests that energy exposure pose an earnings risk for European banks rather than solvency risk, like some investors seem to worry about.
Additionally, there are some banks that have some exposure to commodity exposed countries, like Standard Chartered and Banco Santander (NYSE:SAN), where second-order impacts from the weakness in commodity prices can hurt credit quality on consumer and corporate loans. This is clearly visible in Brazil, where economic activity is contracting rapidly and will certainly lead to more non-performing loans down the road, compounding on the weakness from direct exposure to the commodities sector.
The current low interest rate environment in Europe is negative for banks' revenues with deposits near zero percent and the reluctance to implement negative rates for retail customers, meaning that net interest margins will be negatively impacted if the European Central Bank lowers further its interest rate. After recent moves from the Bank of Japan and Bank of Sweden, the risk that the ECB may follow has turned investors more cautious on European bank's earnings outlook going forward. Even though average loan growth as turned positive in Europe in 2015, recent experience in Denmark and Sweden suggest that negative interest rates do not stimulate loan growth that much, therefore loan growth should not be enough to compensate further margin pressure. This may be another headwind for banks' earnings and improvements in the sector's profitability in the medium-term.
Nevertheless, the majority of European banks is still showing improved fundamentals reporting earnings growth mainly due to lower loan losses. The exception comes mainly from banks focused on investment banking business, such as Deutsche Bank (NYSE:DB), that are still suffering from poor volumes on capital markets and many legacy issues like litigation costs and restructuring costs. Over the past few days, Deutsche Bank has been under the spotlight and the bank is now trading at distressed levels. However, I think the bank has many structural issues and needs to perform a capital increase, so investors should avoid this value trap.
Taking this landscape into account the European banking sector faces several issues, but most of them seem to be in a large part reflected in current share prices. For investors willing to take risks should invest in banks that have relatively limited exposure to the commodities and energy sectors, with retail-oriented business models, good capitalization levels and prospects of safe dividends, which are clearly the most attractive players within the European banking sector currently. Within this group are banks like Lloyds (NYSE:LYG), KBC (OTCPK:KBCSY) or Danske (OTCPK:DNSKY) that I've analyzed in previous articles. On the other hand, banks with low capital ratios and exposure to slowing geographies and industries should be avoided, such as Standard Chartered or Banco Santander.
The iShares MSCI Europe Financials Sector Index ETF (NASDAQ:EUFN) sector is now trading at around 0.6x book value, a discount that already incorporates a lot of issues into share prices but still above crisis levels. Additionally, European banks are trading at a large discount to the overall market, making this sector clearly a value play. This appears to be attractive right now taking into account that a lot of bad news is already incorporated, but on the other hand the outlook for the European banking sector is clearly binary. If the European economic recovery continues its path, then banks have clearly considerable upside potential, but if it enters into recession again then the sector still has more downside.
The recent sell-off has been relatively broad based within the sector, making quality banks appealing for long-term investor given undemanding valuations for sound business models of some banks such as KBC or Danske which are among the banks that offer more value over the long-term, which I've analyzed in past articles. For income investors, Danske is clearly the best option due to its attractive dividend yield of 4.3% plus a $1.3 billion share buyback program to be completed over the next twelve months. This amount is near double of its previous buyback program and Danske is one of the two banks currently buying back its own shares, showing how strong its balance sheet is.
Disclosure: I am/we are long ING, DNSKY, KBCSY, DNHBY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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