Despite concerns about a tougher outlook, many of the Eurozone’s biggest banks beat second quarter earnings expectations. Reuters says they have benefited from high interest rates and “bumper investment bank business,” even though their shares were held back. Shares may be lower than anticipated because of business performance – financial results, “where the market suspects the organisation is taking more risk than might be appropriate,” says Chris Burt, Director of the Risk Coalition Research Company. He adds: “Think Titanic powering full speed across the Atlantic making excellent progress…”
Mathieu Rosemain, Tom Sims and Valentina Za write in their article, ‘Eurozone banks see investment banking boost but outlook stalls shares,’ that while European banking shares rose 20 percent between January and July 2024 – reaching near nine-year highs – “the STOXX Europe 600 Banks index was down 0.5 percent after a raft of bank earnings fed into analyst and investor concerns about the sustainability of the sector’s profit growth.”
Deutsche Bank saw a quarterly loss, sending its stock down seven percent – not helped by a lawsuit provision linked to its troubled Postbank Unit. It also axed plans for a buyback and a rise in bad loan loss charges. BNP Paribas expects to exceed its €11.2bn net profit target, but there are concerns at its retail unit because of an 11 percent fall in net interest income (NII).
Moody’s Ratings also believes that Santander’s and UniCredit’s NII have mostly peaked. Risk charges are therefore likely to increase – despite rising profits, which have bolstered investor sentiment. Lenders have nevertheless traded below their tangible book value, raising concerns about whether their profitability is sustainable.
Despite this, BNPP and Deutsche’s investment banking divisions offset any weaknesses, helping to diversify revenue streams in recent quarters. Rosemain, Sims and Za add: “At BNPP, revenue from equities trading and prime brokerage services jumped 58 percent.”
Mixed outlook
Olivier Panis, Associate Managing Director of Financial Institutions Group, Moody’s Ratings, points out that Eurozone bank profits’ outlook was quite stable. The zone’s banks had managed to boost their net interest margins (NIMs) in 2023. He says that “in countries where variable-rate lending predominates, we expected profitability to stabilise.”
Italian and Nordic banks, as well as HSBC, outperformed their peers in the first half of 2024
Moody’s expects banks’ profitability in the Eurozone in 2025 to decline, “but remain strong.” Panis explains that policy rates have started to move down this year, and so Moody’s thinks that most of the margins have peaked. Yet there will be a slowdown in the shift from current accounts to more expensive term accounts.
Panis adds: “Steady economic growth and inflation close to central bank targets will offer the opportunity for stronger lending volumes, after two years of modest lending activity, while also supporting asset quality and risk charges.” He nevertheless sees operating costs continuing to rise, though. This is put down to technology and higher compensation costs. Despite this, Moody’s thinks there might be some diverging profitability trends between banking systems with a higher proportion of assets at variable rates – helped by increased interest rates in countries such as Spain, Portugal and Italy.
Fitch Ratings believes that Europe’s largest banks are likely to achieve 2024 profitability in line with the strong levels of 2023. In its ‘Large European Banks Quarterly Credit Tracker’ for September 2024, Fitch found that most of the 20 large banks performed well in the first six months. They achieved “better than expected earnings,” which led it to push its full year forecasts upwards for some banks. For example, in a press release it says Italian and Nordic banks, as well as HSBC, outperformed their peers in the first half of 2024. They were expected to continue to perform strongly from July to December. However, French banks are lagging behind their peers, and are only expected to achieve moderate profitability improvements.
Hugh Morris, Senior Research Partner at Z/Yen, concurs that the outlook is generally positive. He says the growth rate in the Eurozone is probably in the realm of three to four percent, and that should feed through to bank profits across the banking sector because half of Eurozone bank lending is mortgages, which have been generally experiencing low levels of demand over the last couple of years. The ECB, he explains: “thinks the banks will be able to improve with a forecast of global GDP growth of 3.4 percent for the next two years. The ECB believes that the Eurozone will not be too far off that. One of the drivers is that mortgages are expected to see long-term growth, whereas previously they weren’t growing at all in the Eurozone.”
Net interest income
To Morris, one of the most interesting things is presented by the banks’ net interest incomes (NIIs). They are at the core of banking medium-term profits. Factors that drive short-term growth include cost management, which he says has been a real driver of BNP Paribas. He explains that NII is the bedrock measure because other factors can come and go. Morris adds: “BNP had record profits, for example, partly driven by cost management. Over a 40–50-year cycle, when banks must manage costs, they do so, and when they don’t have to, they don’t. The market is sceptical about whether BNP can sustain aggressive cost management, and it therefore looks at NII. That’s at the heart of the dilemma. Why is the market sceptical about BNP? NII is a big piece of the answer.”
Continuing, Morris said: “There could also be a full-scale war in the Middle East. If that part of the globe sneezes, the whole world will catch a cold. There has been an increase, caused by more than Ukraine, to Brent Crude Oil prices. These types of price shocks will hit investment decisions and bank lending. Nobody knows what is going to happen, but these are the major factors.” Morris also sees the Eurozone being on a slow growth path, and predicts that a lack of latent productivity in the West will put a cap on banks’ growth.
Banks held back
As to why some banks have been held back, it is possible that they were undervalued and that they are not getting the full reflection of profitability. Morris believes this could be due to concerns over NII and the sustainability of headline profits. “Much depends on how each bank is made up, and there is cyclical falling in love and out of love with investment banking as a way of kick starting growth,” he remarks before adding: “Deutsche Bank paid a huge penalty for getting that wrong. They set out to be a global investment bank to compete with the Americans 20 years ago, but five to 10 years ago the wheels fell off it. It is the 22nd largest bank in the world, and by assets it is smaller than Santander. It is only just bigger than the Toronto Dominion Bank by assets. Stock markets are trying to price in the value of future performance, and the markets see NII as a key indicator of medium-term performance, and if they see its performance diverging from short-term profits, they will focus more on that.”
Panis explains that interest rate challenges have held some banks back. “The benefits of higher rates to banks’ net interest margins have also started to fade, and this could potentially impact the sustainability of their profit growth,” he says. He suggests that borrowing costs will remain higher than before 2022 – despite central banks’ rate cuts. This will weigh in on borrowers’ ability to repay loans and to refinance themselves.
Making matters worse is the higher cost of living, and the fact that asset values have not materially adjusted since 2022 in Europe. He therefore thinks this could impact asset quality and moderate lending volumes, and adds: “Also, the cost of funding has materially increased, as a result of the monetary tightening, with the end of targeted longer-term refinancing operations (TLTROs), and a material shift in the deposit mix towards more expensive term deposits.” While this shift may have stabilised, the central banks have begun to cut rates again, and the deposit mix remains different to what it was before 2022.
Adding to these challenges are capital market income and costs. He explains that capital markets income supports revenue, salary inflation and one-off items are raising costs, which could negatively impact the sustainability of profit growth. He concurs with Morris, too, that there are multiple sources of uncertainties related to “geoeconomic fragmentation, which could increase volatility, impact banks’ operating environments, their asset risk and profitability.” Prime examples of this are the war in Ukraine and the widening conflict in the Middle East.
The NII impact
Morris nevertheless thinks that the concerns about the sustainability of profit growth are chiefly to do with NII. “It is the bread and butter business and it is not looking so rosy,” he says before commenting that the market has seen the focus on cost control and the fascination with volatile sectors, such as investment banking, come and go.
Europe’s largest banks are likely to achieve 2024 profitability in line with the strong levels of 2023
Despite this, NII is here to stay, even though the market is trying to price its likely performance into the current stock value. To Morris, it is Economics 101 because the share price should be the current value of projected medium-term profit streams. This means “the markets’ perception of forward value will outweigh one set of half-year results,” he explains.
Although he doesn’t know Unicredit well, he considers the company’s CEO Andrea Orcel’s decision to return nearly all profits to shareholders in buybacks and dividends as being an interesting tactic. As to whether it led to a three percent fall in shares, and whether the decision to buy a Belgian digital bank led to a drop in quarterly revenues, he suggests it is an open question – particularly about the latter.
While buying a digital bank will cost cash in the short-term, it could be a good thing long-term for Unicredit. Meanwhile, in the medium-term it is not going to be noticeably clear for at least a little while. “It is this uncertainty that would lead to a fall in its shares, and while the markets like to see innovation, they are wary of money pits and white elephants,” Morris remarks.
Panis reveals that investment banking is creating a boost in business because of higher market volatility, and client transactions are boosting capital markets income. He says this is supporting revenue growth in 2024. This is particularly so for banks that “could be negatively impacted by low commercial banking lending activity, which is the case for instance for French banks.”
Despite that, there is a capital markets business expansion, which he explains “drove a six percent rise in adjusted revenue to $65bn for European global investment banks in Q2 2024, with a significant boost from equity and investment banking income.” Then you have underwriting and advisory fees, which are from underwriting and advising on equity, debt issuances, and M&A deals. He says they are all contributing to overall revenue. Yet Morris also claims that there are fewer deals around, but “when a deal is there to be done, the fees and margins are probably better than they have been.”
There is a need to leverage against the cost-base, and he finds that if you need three people to deliver a $50m deal, you may need them all to do a $500m deal. This means that the cost-base remains relatively fixed, and he advises that this is good while you can “find deals to be done, but when the tide goes out you can be left with an uncovered cost-base.” Profitability tends to be very volume-dependent because of increasing economies of scale.
Capital market diversification
Investment banking has nevertheless profited from a diversification of capital markets activities in Europe – partly due to events such as the Covid-19 pandemic, which led to some banks experiencing material losses. Panis says some banks also decided to reduce their risk appetite limits to certain exotically structured equity derivatives.
Geopolitical crises, such as the Russia-Ukraine war that caused price instability, also led banks to develop more balanced global market divisions with a more diversified product mix. Yet while he says European banks do not all have an equal access to the depth of the US capital market, “this diversification is rather credit positive, when implemented successfully, because it exposes less the overall business model of those banks to market turbulences and makes capital market revenues relatively less volatile.”
Morris nevertheless feels that some banks are papering over the cracks, and that banks should return to their core purpose – acting as a store of value. To him banking ought to be a medium-margin, dull business. However, he thinks that “human ingenuity has added multiple layers of risk and complexity to that, to the point that banks’ report and accounts” make balance sheets extremely difficult to interpret accurately. This causes a misinterpretation of share value and causes a wobble.
Yet to banking futurist and author Brett King, there is a need for philosophical change and a need to rethink how performance is measured to align investments with “broader social initiatives and shifts in value creation.” Despite their gains, he says investment banking is simply not fit for purpose for the world we are moving towards today. To continue to prosper, he believes investment banks, and banks more generally, need to have fundamentally different thinking. In his view, this requires more diverse income streams that are aligned with emerging value systems.
