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The State of UK and European Banks

VIDEO: European banks are trying to build larger capital buffers to protect themselves against continental turmoil, but this may not be enough

Jeremy Glaser 16 November, 2012 | 6:01AM Erin Davis

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. I am here today with Erin Davis. She is our senior analyst covering European banks. We're going to see how the banks are holding up in the face of the euro crisis.

Erin, thanks for talking with me today.

Erin Davis: Hi, Jeremy, I am happy to be here.

Glaser: So let's talk a little bit about how the banks are kind of coping with the turmoil. Certainly, things seem to have calmed down a little bit from this summer, but there are still some problems out there. How are the banks doing?

Davis: Well, we are seeing the banks in general trying to build up as much of a buffer as they can against resumed turmoil. They are retaining capital as much as they can by paying out nominal, if any, dividends, and selling any noncore businesses that they can spare and find a buyer for. They are also selling their riskiest assets like troubled sovereign debt as much as they can find buyers. And we're also seeing banks cut their exposure to Greece as much as possible. The two big French banks that had Greek subsidiaries recently both sold them for a nominal EUR 1 each taking big losses on the transaction.

Glaser: So, when you look at the problems that might be facing the bank, is it kind of these big macro issues that have happened in Europe, or is it really the loan losses--the money that they lent out just isn't coming back anymore?

Davis: I think that that varies a lot by country. In stronger countries like France and Germany and even the United Kingdom, we are seeing fairly stable loan losses. In other countries like in Italy and Spain, we're seeing higher and higher loan losses, not enough that they're causing the banks to tip into the red in general, but it's getting there. And in Ireland, we're continuing to see very heavy loan losses.

And when thinking about loan losses in Europe, I think that it's important to consider the differences between international accounting standards and U.S. accounting standards. In international accounting standards, banks aren't allowed to build up as much of a cookie jar against loan losses as they are in the U.S. In the U.S. it's not uncommon to see banks holding reserves worth 300% of their nonperforming loans, but in Europe, numbers more like 40% are common. So that means that as the economy has continued to slip into recession, we're likely to see higher and higher loans losses.

Glaser: So when we look at capital then, are the banks adequately capitalized to withstand these losses?

Davis: I think that that's a very hard question. All of the banks that we cover, which is all of the major European banks, are all very well-capitalized by regulatory standards. They far exceed the minimums. But at the same time, when we look at their underlying capital ratios, and even after we adjust for accounting standards, U.S. banks are far better-capitalized than European ones. And there are different reasons for this. There are some different business model mixes, but there are also some ways that are different about how the banks are measuring the risks that I think probably two companies have the same underlying risk but are measuring them differently. And as a result, European banks seem to be much less well-capitalized than U.S. banks.

Glaser: So will the banks be able to handle an event like the breakup of the euro?

Davis: I think that that depends on how you define a breakup of the euro. We've had a long time to prepare, and banks in general are pretty well-positioned to withstand a Greek exit. As we discussed before, the two French banks sold their Greek subsidiaries recently and no major European bank has a really large Greek subsidiary anymore.

On the other hand if a Greek exit meant that investors started to question whether Spain, or even worse, Italy, were going to exit too, we'd see lot bigger problems. In Italy, they've issued a lot of sovereign debt that banks all around Europe hold, and I don't think that the banks could easily absorb those losses.

Glaser: So if we look at investing in this sector, is this just the case where there is just too many question marks and you can stay away, or are there certain opportunities that look compelling right now?

Davis: We see a couple of names we like in Europe. In general, European banks have traded up a lot since summer, and so we're seeing a lot less compelling value in the sector, though we continue to see a lot of risk. There are two names in particular that we're recommending right now. The first is Julius Baer which only trades in Switzerland, except on the pink sheets in the U.S. And it's a pure-play private bank in Switzerland. And it's recently bought Merrill Lynch's non-U.S. wealth management operations.

And this is a pretty good opportunity for Julius Baer because it means that after the transaction is completed, about half of its assets under management will come from fast-growing markets, mainly in Asia, which means that it will pretty easily hit the upper end of its 4%-6% assets under management target every year. The markets are kind of down on the transaction because of the complexity of the merger, and so I think that that's created a buying opportunity for investors. And we think that management is up to the task. They completed a similarly transformational merger in 2005.

And then the second name that we like a lot right now is Royal Bank of Scotland, which trades in the U.S. and the U.K. under the ticker RBS. And it's a riskier play, and I would caution investors not to pile in; it's really more of a portfolio play. But what I like about it is that it's trading at about half of tangible book value, even though it's about as well-capitalized as a U.S. bank and one of the most well-capitalized banks in Europe in general. It's about 85% owned by the U.K. government after its disastrous financial crisis and its subsequent government bailout.

But the bank has sold off about 75% of its noncore assets. It's really done a lot of the heavy-lifting of turning itself around. It's been reporting almost nonstop losses since the financial crisis. But I think that because of its much smaller noncore portfolio, that's about to change. And then more importantly because the bank is so well-capitalized, it's unlikely to need a dilutive capital raise, which means that even if it's only able to earn 6% in the medium term, which I think it will do better than that, it's still a pretty good buy at today's prices.

Glaser: Well, Erin, thanks for update on the sector today.

Davis: Thank you, Jeremy. It was good to be here.

Glaser: For Morningstar, I am Jeremy Glaser.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
Julius Baer Gruppe AG42.96 CHF0.21
Royal Bank of Scotland Group (The) PLC360.00 GBX1.44
About Author

Jeremy Glaser  is markets editor for Morningstar.com, the sister site of Morningstar.co.uk.