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European Banks Strategy
Key points
􀂄 Banks have performed strongly year-to-date. Overall, European banks are up 47% since
1 January 2009, outperforming the wider market by 32%. Of our universe of 47 banks
covered, only 3 are down in absolute terms. As a consequence of this rally, the banking
sector is now trading on 1.4x 2010E price to tangible book value.
􀂄 In this report we look at two issues that could drive further positive bank performance.
The first is the (surprising) resilience of pre-provision profitability, and its implications.
The second is the question of whether Western monetary policy will allow inflation
back into the system via monetary policy being too loose too long, and what impact this
would have on the European Banks.
􀂄 On pre-provision profitability, YTD we have seen very little pressure, in spite of low
rates pressuring margins, weak loan growth, and deleveraging. This suggests two
things to us. First, banks appear to have more pricing power than we anticipated.
Second, underlying profitability excluding the credit cycle appears to be mostly intact;
like-for-like pre-provision profit has only declined around 10% 2007 levels. This implies
that sector returns on tangible equity could return to the 20% level over the next two
years; an outcome that is still not priced in.
􀂄 Better profitability is welcome, but the risk is that the banks return to profit but still fail
to provide credit to the broader economy. So far in 2009, this has been exactly what we
have seen. DB strategists believe that “the present “risk management approach” of
monetary policy in the wake of the financial crisis (where the emphasis is on minimising
deflation risks) and the potential return of “fiscal dominance” (where other policy
objectives are subordinated to keeping the government solvent) are likely to induce a
reflationary bias to policies.” Our views on credit provision support this thesis.
􀂄 Although fraught with dangers, we think that deleveraging through inflation is the
quickest way to get banks to lend again. Whilst very high inflation is destructive for
banks and the wider economy, we would expect a tolerance of moderate inflation to
lead to an increases in collateral values, a decrease in the real debt burden in the
economy. A steeper yield curve will also support investment banking profits, albeit
contrary to popular belief, it is likely to be negative for retail and commercial banks.
􀂄 We have a preference for investment banking plays in our stocks calls, as short-term
we are optimistic on Q3 and H2 activity levels, and long-term we see them as
beneficiaries of asset price inflation. But on a long-term view, we are turning positive on
the European Banks sector, because we believe that it will outperform in the more
inflationary environment that we and our strategists believe is ahead of us. Our top
picks are listed below.
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