squo;S hard to be optimistic about European banks: they are operating in a highly volatile economic environment that still seems a recipe for trouble ahead. To start with, take rising capital requirements and mix with new liquidity standards. Then add in constrained economic growth alongside the need for future restructuring and significant cost cutting. Combined, these already make anything close to a “normal” level of profitability very difficult for most. If you then finish off with the rising risk of a sovereign failure in the Eurozone and the inextricable link between the sector’s prospects and sovereign risk, you have a recipe for higher funding costs and even lower profitability in the immediate future. This was further confirmed by the news on 15 December that seven major banks had been downgraded by Fitch on the basis of the increased challenges faced by the big financial institutions. The reason for the downgrade will be familiar. High market volatility and the likelihood that economic growth will be subdued for a prolonged period is expected to make life difficult for banks by restricting their earnings potential and increasing costs.
All of this is bad news for banks, currently relying upon retained earnings to meet the deadline of June 2012 set by the European Banking Authority (EBA) to accelerate the rate at which they are required to build up their capital. If Europe’s banks cannot reach the EBA’s 9 per cent Core Tier 1 capital hurdle then they may be obliged to take government capital, a prospect which is unappetising for shareholders, governments and banks alike.
Against such a negative backdrop, it is easy to see why many investors feel they have bitten off more than they can chew. Investors worry that unless unsecured funding markets reopen, there is a real risk that even aggressive bank deleveraging may not save some of them from an even worse fate. So it’s no surprise that banks are currently trading at valuation levels similar to those seen in the immediate aftermath of Lehman Brothers’ failure in 2008.
But it’s not all bad news. UK banks, for instance, are well capitalised relative to their European peers. Also some banking businesses remain resiliently profitable. These are the comparatively unglamorous bits of the financial system, including transaction processing and other financial markets infrastructure, which tend not to be highly capital intensive. Consequently they are able to achieve levels of profitability well in excess of their cost of capital. On fundamentals, they could expect to achieve relatively high valuations, with payment-processing peers trading at price earnings multiples of up to 20 times, which are well above current European bank multiples.
So if investors are able to stomach bad news in the short term, refocusing towards fee-based and intermediary businesses may be one way for the sector to return to higher levels of value in the future. But after two decades of asset growth and increasing leverage, this would be a major shift in how banks operate. With no Eurozone resolution in sight and plenty of negative sentiment around the sector, investors will need to assess banks’ performance on an individual basis. For the majority of banks, however, we would not expect any return to pre-crisis value levels in the near term.
Nick Rea is a partner and head of the financial services valuation team, PwC.