Over the past decade, European banks have wrestled with rock-bottom interest rates. But with dynamics changing, some markets could see notable profit boosts from even a small uptick in the Euribor.
Most investors appreciate the relationship between rising rates and bank profitability, and indeed, the prospect of rising rates has helped lift bank shares across Europe. But while investors have clued into the benefits of reflation, the market continues to underestimate what this means for banks in some of the most rate-sensitive markets.
This is particularly true in Spain and Italy, where mortgages tend to have a 20-year duration (or longer) but carry variable rates tied to Euribor.
An Eye on Rates
As interest rates in Europe fell to unfathomably low levels over the last decade, lenders found themselves in a tough position: Mortgage interest—and therefore income—fell in lock step with the Euribor, and yet banks only had so much leeway to cut interest paid on deposits, which are their primary source of funding for mortgages. Banks adapted to operating in this environment by cutting costs and improving back-office efficiencies, but margins have nevertheless been squeezed.
Is reflation priced in? We think not. For many of these banks, valuations look cheap both historically and based on global ratios.
This is all to say that even the smallest uptick in rates could boost bank margins significantly. As an example, our team at Morgan Stanley Research estimates that every 10-basis point increase in Euribor could boost earnings in Spain and Italy by 5%.
With interest rates in Europe poised to potentially increase between 50 basis points and 100 basis points over the next three to five years, we think the market is underestimating the leverage embedded in mortgage and deposit businesses, namely for select banks in Spain and Italy. In those markets, a 50 to 100 basis point increase in rates works out to a 120 to 180 basis point increase in return on tangible equity (ROTE).
% Y/Y Corporate Loan Growth by Country (adj sales & sec, NSA)
Is reflation priced in? We think not. For many of these banks, valuations look cheap both historically and based on global ratios. U.S. banks are now trading at twice their tangible book values, whereas many European banks are still trading at or below their tangible book values.
Based on recent experiences for U.S. banks, we think European banks have further upside potential, despite double-digit returns in 2017. Loan growth, moreover, offers yet more upside; we figure that 1% higher loan CAGR in 2017 and 2019 works out to an additional 40 basis point increase in ROTE.
Non-performing Loans Still Warrant Caution
This isn’t to say the benefits will be distributed equally. On the contrary, investors will want to pay particular attention to non-performing loans, particularly for mid-size Italian banks. Whereas a rebound in real estate prices in Spain has reduced NPLs, slow economic growth in Italy remains a concern.
Investors will want to be selective, turning a skeptical eye to banks with a high ratio of non-performing loans. As the ECB moves to deepen Europe's Economic & Monetary Union this year, banks will need to take steps to shrink their NPL ratios.
For more Morgan Stanley Research on European financials, ask your Morgan Stanley representative or Financial Advisor for the full report “Banks, EMEA Banks and Diversified Financials: Key Debates and Questions for Managements” (Mar 13, 2018). Plus, more Ideas.
