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The Lex Newsletter: European banking is having a time to shine

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Dear reader,

The City of London is a jaundiced vantage point from which to survey EU banks. Brexit has shifted the centre of gravity of European finance from the Square Mile to the middle of the English Channel. However, the bearishness of Lex’s London team on European banking predates Brexit. And it encompasses UK lenders in a spirit of equal opportunities pessimism.

Strong results from European banks are posing a test for our lack of faith. The revival of net interest margins in parallel with rising interest rates kicks away one leg of our bearish thesis. This still has the following supports: high politicisation that impedes big payouts and prohibits cross-border mergers; small, fragmented local lending markets; the presence of price-insensitive lenders with public service missions, notably in Germany; and mature economies where tech innovation is disappointingly scarce.

These factors signpost longer-term international investment towards US retail lenders such as JPMorgan Chase and Truist. That leaves local European fund managers to revel in the recent revival of their bank holdings.

Banks in Ireland and Spain were some of the most troubled during the financial crisis. They were the sector’s best performers last year. Bank of Ireland outperformed peers with gains of almost 80 per cent. CaixaBank and Sabadell in Spain rose by half.

Rising interest rates are one reason. Greater faith in local regulators is another. It has become harder for banks to operate with dangerously thin buffer capital. That has improved investor confidence.

Line chart of Indices rebased showing European bank shares

If results from UniCredit this week are anything to go by, 2023 will be the year that Italian banks play catch-up. On Tuesday, chief executive Andrea Orcel unveiled a €5.2bn net profit for 2022. That is almost half as much again as the figure in 2021. As hinted at earlier in the month, shareholder returns will rise with plans to hand over €5.2bn this year, equal to 17 per cent of the market value. Shares rallied strongly on the day, moving close to five-year highs.

Italy’s banks are now in their sweetest spot since before the financial crisis. A combination of rising interest rates, cleaner balance sheets and chunky excess capital underpin the equity story. Spreads on the country’s large sovereign debt pile remain contained after the panic last summer.

Rising interest rates remain the force driving outperformance. UniCredit revenues were €1bn or a quarter higher than the fourth quarter of last year, and net interest income (NII) was 40 per cent higher. Further gains are expected with futures pricing in a European Central Bank deposit rate of more than 3 per cent for the summer.

Line chart of share prices (rebased) showing UniCredit is outperforming

Outside of a central bank rate cut, the biggest risk to NII is rising deposit rates or “deposit beta”. This reflects how fast-rising rates are passed on to depositors. As it stands, corporates are the businesses most exposed to the higher-rate environment.

Orcel has taken precautions in case deposit repricing heats up later in the year, doubling assumptions for deposit beta from 20 per cent to 40 per cent for this year. 

Asset clean-ups across Europe over the past decade mean loan losses remain extremely low by historical standards. Even with a mild recession, a cost of risk — provisions as a share of total loans — of 35 basis points is expected at UniCredit this year, below past recessionary levels. 

UniCredit’s capital returns support the valuation. Tangible book value rose 4 per cent in total last year. But on a per-share basis, it was almost 18 per cent higher. That is flattering a valuation that remains at a 37 per cent discount to tangible book value. Rival Intesa Sanpaolo continues to trade at close to par.

UniCredit is making progress with a plan to return €16bn to shareholders by 2024. Spare capital for a deal seems very likely if 2023 performs in line with expectations. “The best stock in the European sector by far” is how Andrea Filtri of Mediobanca describes UniCredit. He began recommending shares at €10 last year.

Many investors in Italian banks will continue to prefer Intesa Sanpaolo. Italy’s largest bank is likely to deliver €1.7bn of promised buybacks. Its earnings are of higher quality. The lender has negotiated the minefield of Italian bank mergers cannily under chief executive Carlo Messina.

Intesa’s all-share takeover of UBI Banca in 2020 delivered economies of scale and a capital boost via the accounting voodoo of negative goodwill. UniCredit deserves credit, meanwhile, for fending off attempts by Italy’s incestuous power elite to foist Monte dei Paschi di Siena — aka “the sick bank of Europe” — on to it at an unattractive price.

As a group, Italian banks have the problem — or virtue, if you favour geographic focus — that international exposure is relatively low. UniCredit has a sizeable European operation outside the borders of Italy. But Spain’s BBVA and Santander offer greater diversification. BBVA’s Mexican business is thriving, as results today signalled.

What both BBVA and Santander need to demonstrate is that diversification can deliver better results than baskets of bank stocks from the markets where they operate.

Meanwhile, the only European bank stock on which Lex is a medium-term bull is UBS. And the Swiss giant is really more of an international wealth manager than a European retail lender these days.

Andrew Whiffin
Lex writer

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