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Written by: Andrew Birse and Jane Bleeg
The March banking failures in the US and Europe jolted markets. Silicon Valley Bank, Signature Bank and Credit Suisse were different stories. But there is a common denominator: they all succumbed to risks created by higher interest rates that ultimately led to a crisis of confidence and rapid bank runs. This was somewhat surprising, because higher interest rates are generally good for banking businesses.
Investor concerns are understandable, and interest-rate risks warrant vigilance. However, major controversies in an industry often prompt an emotional market overreaction, as share prices are pushed down indiscriminately across a sector. In situations like this, investors who identify mispriced shares can uncover undervalued companies that aren’t vulnerable to the same risks with strong long-term return potential.
Dynamics Are Different in Europe
Europe’s retail banking sector is rooted in a resilient business model, in our view. Banks in Europe generally have a much larger retail deposit customer base than their peers in the US, where money market funds are popular vehicles for deposits. As a result, many European lenders source more of their funding from millions of household and business depositors. In our view, these customers represent a highly diversified and sticky base, which reduces concentration risk—the danger of a relatively small number of large clients withdrawing their funds simultaneously.
What do banks do with these deposits? Some funds are parked at central banks, where the lender earns interest and enjoys liquidity. Other funds are lent out at higher rates, and banks earn income from the spread between interest rates of deposits and loans. This is known as net interest income—the most basic source of banking earnings.
Higher interest rates help banks earn more net interest income. This is a very different dynamic than the one faced by SVB, which paid a heavy price for investing in Treasury bonds that got hit when interest rates rose. Banks that rely on net interest income as the bread and butter of their earnings mix should benefit in today’s high-rate environment.
Europe’s banking sector offers fertile ground for finding banks like these. Net interest income has posted solid growth in recent years (Display). And European banks have enjoyed stronger earnings upgrades than any industry in the region.
Higher Rates Can Help European Banks Boost Income Further
Past performance and current analysis do not guarantee future results.
*Based on net interest income from 48 European banks.
†Percent change in consensus earnings per share (EPS) estimates for calendar year 2023 on April 19, 2023, vs. estimates three months earlier.
Left display through April 18, 2023; right display as of April 19, 2023
Source: Autonomous Research, FactSet, MSCI and AllianceBernstein (AB)
Banks have also beefed up their liquidity coverage ratios to about 165% on average, according to our research of 33 European lenders. That’s well above the 100% requirement mandated by the European Central Bank for the liquidity ratio, which measures the extent to which banks have enough liquidity to withstand a 30-day funding stress scenario. Non-performing loans have also fallen to below 2%—from a peak of 6.8% nearly a decade ago—providing a comfortable cushion if customer defaults increase in an economic slowdown.
These positive features don’t seem to be appreciated by the market, in our view. After the recent sell-off in the sector, European banking shares trade at a record 49% price/earnings discount to the broader equity market (Display).
European Banks Trade at a Deep Discount to the Market
Past performance and current analysis do not guarantee future results.
Through April 18, 2023
Source: Bloomberg, STOXX and AB
Tight Regulation Is Already in Place
Skeptics might be concerned about the impact of potential new regulation on banking earnings. However, we believe that the European banking sector is much less vulnerable to new regulation than the US industry. Even before the recent failures, European banking regulation was already much more stringent than in the US. In fact, European banks of all sizes are subject to the same regulatory and capital requirements, unlike in the US, where different rules apply for different-size institutions. As a result, we don’t anticipate a wave of new regulation in Europe that would threaten to erode banks’ earnings.
Of course, banking is fundamentally about confidence. Recent events serve as a reminder that no bank can survive a run on its deposits, which can happen extremely fast in the internet era. We also know that lending at ultra-low rates, as we’ve seen in recent years, can lead to bad debt issues over time as interest rates rise and weaker borrowers can’t meet their financing obligations. Banks are also likely to face higher wholesale funding costs after the recent turmoil, as perceptions of risk have changed. No bank is immune from these trends.
However, not all banks are created equal. In Europe, we think the already-rigorous regulatory environment and a generally sound banking business model provide a robust backdrop for lenders to traverse diverse challenges. Attractively valued banks, with diverse customer bases and business models that clearly benefit from higher interest rates, deserve special attention today. By finding them, investors will discover that an unpopular sector can be an uncommon source of strong long-term return potential in equity portfolios.
Related: How Will the Banking Crisis Reshape Financial Credit?