Be discerning about Europe’s banking sector

Kathleen Brooks
THE last two years have been cataclysmic for the global banking sector. Yet most banks managed to stay afloat during the financial crisis and have returned to profitability this year. And after the wave of volatility that hit the markets in recent weeks, banking stocks are beginning to look cheap.

But should investors be buying up banks with low price-to-earnings (PE) ratios in an attempt to bag a bargain? Most analysts would say no. Although the financial sector is in better shape now than in September 2008, more stringent regulation and higher levels of taxation are the newest clouds gathering on the horizon.

Yet one can make money in the sector and spread betters need to have a discerning eye when it comes to trading the banks. Analysts at UBS favour banks based in economies that largely dealt with the financial crisis during 2008-2009 – for example the UK and the US – and it has a buy recommendation on Lloyds Banking Group, HSBC and Barclays. Compared to the US and the UK, European banks are still reliant on the Europeam Central Bank (ECB) for funding. Whereas US banks’ usage of the Federal Reserve to borrow funds has shrunk from $700bn at the peak of the crisis to less than $100bn earlier this year, the ECB has had to ramp up their lending to banks within the Eurozone; in May it lent $800bn, close to what it was lending in October 2008 when Lehman Brothers failed.

The question now is how well Europe’s banks would perform if the ECB was to remove its funding, thereby forcing banks to raise cash in the private markets. Another reason for the ECB’s lending, according to UBS analysts, is that European banks have not raised enough equity to absorb the losses experienced during the recession. Since the regulators are likely to ramp up capital demands for the banks, investors should look for those banks with the best capital ratios.

Analysis by S&P Equity Research has found that strong profits in the first quarter of this year provided a boost to Swiss banks Credit Suisse’s and UBS’s Tier One capital ratios, which is the key measure of a bank’s financial health. For example, UBS’s core Tier One capital ratio rose from 15.4 per cent in the fourth quarter of 2009 to 16 per cent in the first quarter of 2010.

However, according to S&P Equity Research, Deutsche Bank actually saw its core Tier 1 Capital ratio fall to 7.9 per cent in the first quarter of 2010, from 8.7 per cent in the last quarter of 2009, due to its acquisition of wealth manager Sal Oppenheim, as well as a change in regulatory reporting standards. But S&P Equity Research notes that even without the acquisition, Deutsche’s capital ratio would still have seen a slight decrease. This suggests there will be increasing pressure on the bank to improve its capital base.

Instead, S&P Equity Analysts have a strong buy recommendation for Banco Santander (see In Focus box). It argues that Satander is particularly cost efficient and has a low cost-to-income ratio compared to other European banks. It is also attracted to its favourable geographic mix: Latin America has overtaken continental Europe as the group’s main revenue provider.

UBS argues that Societe Generale, the French investment bank, is also an attractive buy because of its diversified business model, which includes an international retail bank. Also, at current prices, Societe Generale looks good value and has a PE ratio of just over 10.

The readjustment in the European banking sector is far from complete, but for investors with a medium-term time horizon now is a good time to get in early and gain exposure to the best positioned European banks.

When Standard and Poor’s, the ratings agency, first downgraded Spanish debt in April, many analysts expected Banco Santander to sail through the turbulence. At the time, analysts at both S&P Equity Research and RBS recommended buying the stock. Santander, which owns Abbey, Bradford & Bingley and Alliance & Leicester – saw its share price fall sharply as the bad news continued with another downgrade for Spain in late May.

Its Madrid-listed shares recovered to close on Friday at €8.73, after its chairman Emilio Botin said that profit this year would be similar to that of 2009 – the group reported pre-tax profits of €13.48bn last year. In its first-quarter, net income jumped 5.7 per cent to €2.21bn. It also announced last week that it planned to buy back a large stake of its business in Mexico, which it sold to Bank of America in 2003 for $2.5bn.

S&P Equity Research reiterated its strong buy rating last week on the back of the deal. Investors have been skittish but the bank’s bottom line is relatively insulated from Spanish troubles – only 25 per cent of its operating profit comes from Spain. Since the start of 2010, its price-to-earnings ratio has fallen to 7.65 times from 11.31 times.

Juliet Samuel