Thread by @jeuasommenulle

For some strange reasons there seem to be a flurry of tweets and takes about the incoming crisis of Eurozone banks – probably partly triggered by Raoul’s tweets, partly by those chart below. So a quick thread on the situation of EZ banks today.

https://twitter.com/TheStalwart/status/1160538888290603009

Yes, the index is at a all time low, but is it hugely relevant - if you’re a long-term shareholder it certainly is, but more generally? Has something changed recently to justify the fears?

First thing: Q2 wasn’t that bad. In fact, it was better than expected. Banks’ results were approx +6% above consensus, with star performers being Intesa, UBS or Natixis and laggards being Unicredit, Deutsche and Commerz.

In terms of revenues/costs split, there was no clear trend, but I’d say we saw more revenue beats and costs misses. Clearly revenues were not the dark spot (less than 10 misses) despite all the talks about negative rates.

Of course, the problem banks are facing is more forward looking: consensus was slightly downgraded post results (PBT approx. -1%) and this was entirely because of lower revenues assumption and because of Ze Germans.

Importantly, capital and NPLs continue to improve. A substantial majority of banks had better capital and lower loan losses. All is green on the balance sheet front.

So why the ugly equity chart? You need two perspectives on this chart: a long term and a short term one. The long term one states the obvious: EZ banks have performed terribly over the last decade because of:

Massive new capital requirements: rule of thumb is if you make the same money as 30 years ago, you need 5x more equity, so ROE divided by 5, so share price divided by 5

Massive deleveraging post crisis: less interest earning assets and, in some cases, lower book value

Unconventional monetary policies and negative rates.

So the ugly price performance is simply the consequence of a seismic shift: bank shareholder money has been used to dramatically boost systemic stability. Which is good globally, I guess.

From a shorter term pov now, clearly the recent performance is "yikes". Why? SG has put together a rather simple but enlightening indicator supposed to describe the quality of the environment banks are making business in.

They call it the “Misery curve” and it’s a mix of inflation, rates and GDP. I won’t go into the details but it’s rather straightforward that higher inflation, rates and GDP are good for banks profits and vice versa.

And on this front, recent data is poor: Euribor is down (thanks Mr Draghi), so is forward GDP and (to a lesser extent) inflation. So all banks traders are factoring this in future revenues and LLP forecasts

Is this something we should worry about? Obviously, the voodoo view that if the index touches a all time low or a “support” is rubbish, and nothing will happen quickly.

Obviously (bis) the poor share price performance is a direct consequence of increased stability and robustness of banks. So there is no “crisis signal” in the index performance, just a clear illustration of how the world changed.

But there is still something very important going on; for the time being banks are still making money, as you can see below (SG again).

Even if EZ banks operate in the worst environment, the bulk of EZ banks is still above the 7% ROE mark – nothing dramatic. But this is still somehow a binding constraint on monetary policy.

As the case of DB shows, the ECB is concerned with systemic banks with sub 5% ROE, if only because it drastically reduces their financial flexibility and capacity to raise equity or withhold a recession.

There are still levers to improve profitability in a neg rates environment: reducing costs, lower competition, reducing regulatory burdens linked to neg rates (i.e. mortgage prepayment regulations) etc.

But at some point, we might get to the point where this is not enough or where the ECB realizes that its monetary policy does not work because the banks act as a buffer and prevent its actual transmission instead of allowing it.

Norges Bank has a fascinating working paper on this which shows that the correlation between the CB rate and bank lending rates breaks down when rates reach zero (as I’ve argued a zillion times, this is highly non linear.)

The chart even shows that the correlation becomes negative when rates are below zero – presumably the non linear effects of neg rates destroy bank profitability and they have to raise lending rates to offset.

So this points to the following crucial idea: the ECB will face practical challenges with QE (@fwred has you covered on this) but banks could also end up being the binding constraint for current mon pol. However, this is a long-term process, don’t expect drastic changes soon!

@fwred And remember that the index price chart will only give you a tiny bit of the story 😊

@fwred paging the usual banks geeks ;-)
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