Banking stocks offer a bumpy ride

By Lynn Stongin Dodds

What a difference a few months can make. In the beginning of 2013, fund managers were flocking to the global banking arena for the first time in six years. Fast forward to May and their exuberance has been tempered and positions have been trimmed. Views may differ on the best way to play the sector but all agree the picture has changed since the Bank of America Merrill Lynch fund manager survey in January, which showed the majority were placing their bets on global banks.

“Cyprus was a game changer. For the first time, senior bondholders and depositors carried a material default risk. This will cause an increase in funding costs which in turn will hurt the profitability of European banks.”

Vincent Kester

The managers which collectively had $754bn (€560bn) under management said they were ready to take the plunge for the first time since February 2007 because banks were the most undervalued sector in the international equity arena. The US was seen as leading the pack after the KBW Bank Index, which tracks the nation’s largest 24 banks, posted a 30% surge in 2012. European banks were also on the radar after the Basel Committee on Banking Supervision extended the deadline until 2019 to comply with new rules requiring them to stockpile enough easy-to-sell assets to survive a 30-day crisis. The Committee also amended the way the liquidity coverage ratio is calculated to reduce the total commitment. Previously only cash and government securities were deemed suitable but the fold has been widened to include some equities and mortgage-backed securities.

European institutions had been struggling to meet the more stringent draft rules by their 2015 deadline. This was not the case for the majority of US and Asian banks which were set to meet the original target.

The game changer

It did not take long though for the positive mood to be punctured. In March, the blowup of the Cyprus banking sector served as a painful reminder of the still fragile state of the eurozone. The €10bn lifeline from the European Union and International Monetary Fund was also a jolt in that it differed radically from any other bailout by controversially forcing depositors with over €100,000 to foot the cost of recapitalising banks exposed to debt-crippled Greece.

“One of the lessons from Cyprus is that uncovered depositors should think of themselves as senior unsecured creditors rather than depositors,” noted Barclays Capital analysts in a report published in April. They estimated that higher deposit rates could cost the eurozone banking sector around €8bn annually, or 6% of its profit.

“Cyprus was a game changer,” says Vincent Kester, senior investment analyst, financial shares at ING. “For the first time, senior bondholders and depositors carried a material default risk. This will cause an increase in funding costs which in turn will hurt the profitability of European banks. Also, the results of the Spanish domestic banks were much worse than expected. On top of that there is the financial transaction tax and uncertainty over the eurozone economy. When you add all these things together, it puts banks under pressure.”

Neil Dwane, CIO Europe at Allianz Global Investor, agrees, adding, “If you now look at the most recent Bank of America Fund manager survey, many people are either neutral or slightly overweight in banks. I am sitting on the side-lines because I have some key concerns. You can only heave a sigh of relief if you think they are all fixed. There is a perception that the US banks are in better shape because the country did not follow an austerity programme plus the Federal Reserve was more aggressive with capital restructuring, but if Europe takes another turn for the worse then the interlinking between the two remains.”

There are hopes that the European Stability Mechanism, the eurozone’s bailout fund, could be used to recapitalise the weaker banks and inject stability into thesector. However, the ECB’s supervisory mechanism is unlikely to be operating until the middle of next year and many of the nitty gritty details still need to be worked out.

“The ESM has not made as much progress as hoped in getting a uniform agreement,” says Bill Street, head of investments EMEA at State Street Global Advisors. “If it were to make headway then I think it would have a significant impact on the sector.”

Domestic wobbles

Many market participants are also wary of the UK banking sector. “We fear the industry will continue to be beset by self-inflicted errors and own goals,” says Douglas Mc- Neill, investment director at Charles Stanley. “We are also concerned about credit quality because we have not seen the write-offs that one might have expected. It has been difficult for the government to engineer the competition that is needed as witnessed by the Co-operative pulling out of the Lloyds deal. As a result, the sector is still dominated by a handful of players and in fact the concentration is more than ever since banks such as Bradford and Bingley and HBOS have disappeared.”

Co-operative had been widely expected to lay down the gauntlet but in a surprise move in April it ended discussions to buy 632 branches from Lloyds. If the deal had gone through it would have created a 974-strong branch network – three times the current size of the Co-op bank – and increased its share of current accounts from 2% to 7%. The same thing happened to the Royal Bank of Scotland last year when a deal to sell its 316 UK branches to Spanish bank Santander fell through. Both banks are currently mulling over a stock market flotation for the branches they must sell under European state aid rule.