Investability of the European banking sector

In this Q&A, James Mcdonald looks at the investability of the European banking sector after the banking regulation draft by the EU a few weeks ago.

Investor Relations Specialist

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We had a Q&A from James Macdonald, one of BlueBay Senior Portfolio Managers. In this Q&A he looks at the investability of the European banking sector after the banking regulation draft by the EU a few weeks ago. Here are his thoughts and insights on the topic.

The EU is published a draft new banking legislation on October 27th. What are your thoughts?

The EU published its long awaited legislative text at the start of November which is essentially the EU implementation of Basel IV through EU legislation. The package had already been delayed by a year due to Covid and as we expected there has been some significant watering down of the original Basel proposals following lobbying by the European Banking sector. This said, in our view, the commission has taken a pragmatic approach that captures the spirit of the Basel 4 but at the same time recognises the structure of the European banking market. We also think there is a flavour that policy makers are increasingly cognisant that regulation of European banks has been so intrusive over the past decade that it has perhaps inhibited their role of financing the economy. The sectors response to the pandemic and the role that it played in the recovery process was perhaps a timely reminder which helped the banks in their lobbying of the implementation process.  

The legislation has not addressed the areas in regulation that the pandemic highlighted as perhaps not working so well such as the balance of structural and cyclical buffers, the differing approach of national prudential authorities and the triggers of AT1 coupons and their influence on banks willingness to use their capital buffers which is perhaps a missed opportunity. Given the time of the legislative process – which will now be subject to a trialogue process over the coming years it is perhaps not surprising but undoubtedly is an area that we believe should be revisited.

The banking sector has been criticised for resisting a commitment to net zero targets. Why is this and do you expect this to change? 

While the banking sector has often been criticised for its commitments to net zero targets we are of the view that this is an outdated view and is an unfair representation of the work and commitments being carried out by the sector. In fact, the vast majority of leading banks have now signed up to 2050 net zero commitments with those that have not being the outliers. Indeed, we would be very surprised if any major bank has not signed up to this pledge by the end of the year. Where criticism is more warranted is while banks have been willing to make this pledge, the path and means at which they will get there is much less well defined. There are a variety of reasons for this and it is up to us as investors to ensure that banks provide the market with much more detailed plans, transparency and measurable KPIs on how they will be able to achieve these pledges. We are of little doubt that those that do this successfully will be the winners and the market will be very quick to differentiate between banks on their progress. 

Is net zero realistic for banks if they finance fossil fuel activities? 

We believe its important to recognise the role that banks are playing and will continue to play in transitioning economies and companies into a greener and more sustainable future. While fossil fuel industries are inconsistent with a net zero future there has had to be a recognition that banks should help these companies and their employees to make that journey. Clearly the banks that are exposed to these industries have more work to do than they may do otherwise but in our view the journey and final destination are much more important and can have a much greater impact than the starting point. 

Do you expect further consolidation in the European banking sector? What are the drivers behind consolidation?

We expect European banking consolidation to be a theme moving forward. There is a very large tail of banks in Europe and consolidation would be very beneficial for the sectors profitability. Regulation and the regulatory response to m&a activity is an essential driver for consolidation and in the last year we have seen significant steps by the ECB to oil the wheels of this process with their pre-emptive guide that was designed to clarify their regulatory approach to consolidated entities. There also needs to be clear strategic rationale demonstrated for any consolidation. European bank investors have had a turbulent time over the last decade and this has made management teams and shareholders laser focused on profitability and the elements driving this. With a very mature market from a revenue perspective we are also of the view that cost reduction – in particular growing IT expenditure and the ability to lower the marginal cost of this will be a growing consideration of M&A activity.

What are the challenges to consolidation i.e. does the European Commission need to do more to enable integration?

There are a number of significant challenges remaining to consolidation. The ECB has provided banks with much more comfort over the regulatory approach but political challenges remain. For example, labour laws make it extremely difficult and costly to make headcount reductions that would allow banks to benefit from economies of scale. National protectionism still prevents the free flow of capital and liquidity within Europe, with little progress made on a common deposit insurance scheme that would facilitate this and the fast changing market dynamics and growth of digitalisation combined with negative interest rates has meant that the value of customer acquisitions is much more difficult to evaluate.

View on the Italian & Spanish banking sectors

We continue to see the steps that have been taken in the Spanish & Italian banking sectors over the last decade as extremely positive and in our view this was underscored by their performance during the height of the coronavirus pandemic in 2021. In Spain, consolidation has greatly increased the concentration of the sector, which has benefited the profitability metrics and resilience. In Italy, while consolidation has started, the real strides that have been taken have been in reducing system wide NPLs. From a peak of c.€350bn these have been reduced from a combination of asset sales and work outs to less than €100bn. With this balance sheet clean up largely complete it puts the sector in a healthy position to start the consolidation process that we have seen in other European jurisdictions.

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Investability of the European banking sector