Bad to the bone
It’s a testament to European banks’ dismal prospects that a sharp share-price rally has still left valuations deeply depressed. One explanation is that investors are expecting a huge increase in bad debt. But the deadening effects of perpetual low interest rates are the deeper concern.
Chief executives of the region’s top 20 lenders by market value, from Jean-Laurent Bonnafé of BNP Paribas to Barclays’ Jes Staley, have seen their share prices rise by one-quarter on average over the past 10 days. Yet the institutions still trade at roughly two-thirds of their tangible book value at the end of March. Assuming a 10% cost of equity, that’s consistent with a return on tangible equity of 7%, down from 8.9% on average over the past two years.
The pandemic offers clear reasons for pessimism. Provisions for dud credit surged in the first quarter, as lenders prepared for a wave of virus-induced defaults. Yet the increase in bad debt would have to be enormous to justify the discounted valuations.
As of Monday morning, the banks had a combined market value of $653 billion. If each lender was expected to earn the same return on tangible equity as in the past two years, they should be worth a collective $917 billion. One way to justify the shortfall would be if the banks were about to write off 3% of their combined loan books, which are worth $9.1 trillion.
But that’s more than twice the losses banks suffered in 2009 as a result of the last financial crisis. Besides, the analysis ignores the fact that most banks are continuing to generate operating profit, which cushions loan losses. It also excludes Deutsche Bank, whose massive restructuring charges skew the numbers.
Investors are probably more worried about low interest rates, which squeeze the margins between what banks charge for loans and earn on deposits. Yields remain negative for German benchmark bonds with durations of up to 15 years, and are below 1% for all durations in Britain. That implies rock-bottom policy rates for the foreseeable future.
Viewed through that lens, expectations of low returns on equity make more sense. Investors think CEOs like Bonnafé and Staley will avoid bad-debt Armageddon but shuffle into zombie status. It will take a sustained revival in long-term interest rates to avoid that fate.