Chart of the week: What yields banks
Source: Refinitiv Datastream, Aberdeen Standard Investments (as of 14 May 2019)
European banks have had rough ride since the global financial crisis. The Euro Stoxx Banks Index has returned an underwhelming 61% on a total return basis since its 9 March 2009 low (returns are 65% when calculated from the nadir, reached during the 2011/12 European debt crisis). This is far short of the wider index’s total return of 182%.
Comparatively, in the US, the S&P 500 Banks Index is up 692% on a total return basis over an almost identical period. This outstrips even the S&P 500 Index’s spectacular 418% return from its low.
Why are US and European banks an ocean apart? It has to do with the way each region reacted to the global financial crisis. US policymakers responded rapidly by introducing the Troubled Asset Relief Program (TARP) and quantitative easing (QE) measures. TARP, run by the US Treasury, sought to stabilize the country’s financial system by purchasing troubled companies’ assets and stocks. Through QE, the US Federal Reserve (Fed) artificially lowered interest rates to increase the money supply, provide banks with more liquidity, and thus support business.
The European Central Bank (ECB), on the other hand, raised rates in 2011, while QE did not begin until a few years later. Furthermore, banks failed to recognise underperforming loans for too long. Politics played a role, too. While many in the US may have grumbled about QE measures, US banks were still able to repair their balance sheets early on. In Europe, there is not the same level of political will to assist banks to the same degree.
So where does Europe go from here? The next course may be to look to Japan. There the financial system has adapted to lower interest rates and lower growth. European banks will have to do the same, especially with the ECB on hold until 2020 at the earliest. The deposit rate is likely to remain in negative territory until at least 2021.
The yield curve is a good tool to measure banks’ profitability. Deposits (liabilities on banks’ balance sheets) generally have shorter time to maturity, while profit-making loans (assets) have longer time to maturity. The spread between two-year and 10-year German government bond yields provides a good example: the relative steepness of the curve has been a good proxy for banks valuation versus the wider index.
What will need to change for investors to be able to bank on the banking sector? A steeper yield curve would boost profitability and encourage banks to take more credit risk. Additionally, policymakers should alter their pro-cyclical regulations. Banking supervisors typically respond to a fall in credit demand by forcing banks to increase capital buffers or tighten lending standards. These reactions only exacerbate the fall in credit provision.
Investors should take a holistic approach to their portfolios. Investing in what’s cheap isn’t guaranteed to be profitable in the long run. Surprise scandals like money laundering can also have far-reaching ramifications. Certain regulators and policymakers may try to use such events to increase government control of the financial sector. The lesson here is that investors should always dig deeper into what they’re buying.
RISK WARNINGThe value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.
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