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Categorized | Equities

Bargain basement banks not such a bargain

Posted on March 31, 2013

A woman walking past a branch of the Bank of Cyprus branch in Nicosia, Cyprus 27 March 2013 as the country's banks remain closed. Cyprus banks will are expected to open early 28 March. Temporary measures will be placed on transactions when they do re-open despite the EU/IMF bailout deal which will see larger depositors lose money.©EPA

Is it time to buy European banks?

This column last posed that question in June, and concluded – from an analysis of their balance sheets and accounts – that banks were cheap, but there was no “margin of safety”.

Buying bank shares remained an almost pure bet on the broader progress of the eurozone crisis.

So it proved. The FTSE-Eurofirst banks index rallied 72 per cent from last summer’s lows, and this was far more attributable to three words from Mario Draghi of the European Central Bank – “whatever it takes” – than to any developments at the banks themselves.

    Now, the crisis in Cyprus – the worst alarm in the eurozone since then – has produced what optimists might call a nice buying opportunity.

    Eurozone bank share prices have tumbled 21 per cent – a new bear market – in a matter of days, and are now at their lowest since last September.

    On some measures of valuation, they also look more attractive.

    European bank shares trade on only 63 per cent of their book value, up from the bargain basement 46 per cent level last summer, but still mighty cheap. The valuation gap between European bank shares and those in the US, which now trade on 95 per cent of book value, is at its greatest since 2004.

    And the European multiple itself is no higher today than it was in July 2011, even though repeated actions and words from the ECB since then have shown that banks will not be allowed to go down without a fight.

    At such valuations, banks look a buy on almost any outcome, other than a disaster.

    But this is when the optimism must stop. Cyprus has set important precedents, which cannot be reversed.

    First, the initial proposal to deal with the problem proposed taxing insured deposits. Even though this was quickly abandoned, the fact that reneging on deposit insurance was even considered was a hugely important precedent – which greatly increases the vulnerability of the European banking system as a whole to runs by depositors.

    In an ideal world, deposit insurance would not be necessary, and the job of vetting banks could be left to depositors. Even in a world of insurance, the insurers would ideally do a good enough job to stop banks from growing insolvent and putting depositors’ money at risk. But this is not an ideal world, and this was far too early to propose reining in deposit insurance.

    Second, Cyprus’s capital controls effectively mean that the currency union is no longer in full force, as Cypriot euros are not fully convertible for other euros. This is another important precedent.

    Third, the focus on the scale of Cypriot banks’ assets in comparison to the island’s economy has brought attention to a few other small centres with huge banking systems in proportion to their size. Names such as Malta and even Luxembourg, the EU’s wealthiest nation, are now mentioned.

    Finally, come the ill-advised words of the Eurogroup’s president, Jeroen Djisselbloem, who made clear that “bail-ins” will be the norm in future. Banks’ creditors, of whatever seniority, can expect to have to chip in for any future rescues.

    What are the concrete effects of all these changes on bank stocks?

    Any bank with a high loans-to-deposits ratio will be obliged to raise its capital ratios. Any way of doing this – from disposing of assets to selling new equity – will be bad for the share price. As it is obvious that there will be a greater supply of bank equity, its price will have to fall to attract buyers, making bank equity less attractive as a source of funding.

    At the same time, even the most senior bank credit has now become less appealing to investors. Deutsche Bank’s Jim Reid demonstrates this dramatically by showing the spread between senior financial debt and low-quality crossover (ie between investment and non-investment grade) debt. That ratio, once as high as 33 times pre-Lehman, is now down to its most compressed level ever, at about 2.5 times. It will be more expensive for banks to raise credit.

    And, of course, it will be far harder to take in deposits. Depositors are likely now to start differentiating. Banks in jurisdictions that have raised the most concerns to date will find life harder. Figures from SNL Financial show that loan-to-deposit ratios are far higher in Europe (at 106 per cent) than in the US (69 per cent). Banks with high ratios must already rely very much on other sources of funding. That reliance can only increase, meaning that such banks will need to hold larger reserves of liquidity – making them less profitable.

    So, while eurozone banks are now cheap, they are not a bargain.

    Berenberg Bank suggests buying conservatively-run banks with low loan-to-deposit ratios, such as HSBC, UBS or Handelsbanken. But the rational course for equity investors – doubtless now being put into effect by hedge funds – is to sell short the shares of other banks that look more vulnerable. This is inherently dangerous. But the policy response to Cypriot events of the last two weeks has encouraged investors to do just that.