European banks outlook: sluggish earnings, weak returns

Investors in European banks will have to put up with “sluggish earnings and weak returns” for the sector next year, analysts from European rating agency Scope Ratings have warned.

This is partly due to the difficult macroeconomic situation that Europe is still facing and partly due to the continuing process of sorting out the legacy of the financial crisis, which is more advanced in some countries than in others.

European banks bad loans

European banks’ imparied loans vary depending on country. Source: Scope Ratings

On the plus side, the European Central Bank’s recently finished Asset Quality Review has shed light on a practice that for a long time had obscured the real problems faced by banks: extending and pretending — extending the duration of loans that should have normally been declared non-performing.

“Going forward, we believe this forbearance process will be more transparent,” Sam Theodore, group managing director at Scope Ratings, said during a presentation of the rating agency’s outlook for the banking sector.

This should help boost European banks’ credibility but they will still be dragged down by the unequal pace of dealing with bad debt.

“In Italy for example, the legal system makes it very difficult to resolve non-performing loan situations in an economically acceptable timeframe,” according to Scope Ratings analysts.

This is why Italian banks carry large loads of impaired loans and it is the key reason why several Italian banks failed the ECB’s stress tests.

Banks in Ireland, Spain or Portugal will be able to resolve the legacy of their non-performing loans much faster than banks in Italy or Greece, the Scope Ratings analysts predict.

Lower levels of loan loss provisions are likely to help European banks’ profitability levels next year, but “the positive effect is not likely to be spectacular.”

There will be some scope for mergers and acquisitions, as “there are countries in Europe where you have some degree of fragmentation,” Marco Troiano, associate director at Scope Ratings, said.

“There are massive amounts of branches in Italy and Spain. There is potential to cut down costs, and this will happen through consolidation,” Troiano predicted.

The M&A is likely to take place once all the regulatory requirements in Europe are known.

European banks to issue more debt

European banks are likely to issue “a lot” of securities next year and in 2016, in order to cover their shortfalls under the minimum requirements for own funds and eligible liabilities (MREL), Theodore said.

Under the EU’s Bank Recovery and Resolution Directive (BRRD), investors and creditors making up 8% of a bank’s total balance sheet will have to be bailed in first, if a bank gets into trouble, before the bank can access other forms of funding.

Out of 22 EU/EEA banks rated by Scope, only two – BBVA and Intesa – currently have instruments exceeding the MREL 8% limit under the BRRD.

Scope Ratings’ analysts expect that the gaps will be filled with Additional Tier One (AT1) and Tier 2 securities. These include hybrid instruments, such as contingent convertible bonds, which under certain circumstances turn into equity.

Banks may issue other junior debt that does not qualify as regulatory capital, or senior unsecured debt to fill the MREL gap.

European banks’ outlook shows that they have put the crisis behind them, but they still have skeletons in the closet.

One of the most important risks going forward is conduct risk, something the ECB stress tests did not measure.

“Conduct risk is still opaque, difficult to see by outside participants,” Theodore said. “For the European Banking Authority, this will be a growing area of concern.”

@AntoniaOprita

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