BUILDING TOMORROW™
The State of Banking: Macro Credit Research Still Unstable Bloomberg FI14 Forum, June 2014 Alberto Gallo, CFA Head of European Macro Credit Research +44 (0) 20 7085 5736 [email protected] Lee Tyrrell-Hendry Macro Credit Analyst +44 (0) 20 7085 9462 [email protected]
Shikhar Sethi Macro Credit Analyst +44 (0) 20 7085 6479 [email protected] Tao Pan Macro Credit Analyst +44 (0) 20 7678 3122 [email protected]
Rajarshi Malaviya Gaurav Chhapia Chanchal Beriwal
Produced by The Royal Bank of Scotland plc. In the UK, the Royal Bank of Scotland plc is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct rbs.com/mib Authority and the Prudential Regulation Authority. Why do banks exist?
1. To optimally allocate resources in the economy 2. To borrow short-term andQE lend long-term 3. To promote new businesses and growth 4. To provide safe savings for depositors 5. To generate sustainable profits for shareholders
2 The original sin of European banking Frequency of the words “debt” and “sin” in English language books
QE
Tulip-mania
1929 crisis 2008 crisis
Source: Google Books, Ngram Viewer 3
Of that seventh circle, where the mournful tribe
Were seated. At the eyes forth gush’d their pangs, Against the vapors and the torrid soil Alternately their shifting hands they plied. Thus use the dogs in summer still to ply Their jaws and feet by turns, when bitten sore By gnats, or flies, or gadflies swarming round. Noting the visages of some, who lay Beneath the pelting of that dolorous fire, One of them all I knew not; but perceived, That pendent from his neck each bore a pouch With colours and with emblems various mark’d,
On which it seem’d as if their eye did feed.
The Divine Comedy, Inferno XVII
Source: RBS Credit Strategy, Wikipedia 4 Banking: a for-profit business or a social and political activity?
Charging interest was sinful for the Catholic Church since Pope Leo the Great The Lombards started loans on collateral, which was not forbidden. Lombard credit spread throughout Europe Italians became famous bankers: the Medici Bank (1397-1494) was the largest banking institution in Europe To fight lending at high interest rates and usury, the Franciscans created the mount of piety, a charity institution to lend at modest rates. They also spread throughout Europe Germany’s landesbanken and sparkassen, Italy’s popolari and cooperative, Britain’s building societies and Spain’s cajas all have ties to local authorities and a high percentage of public ownership and/or non-negotiable control
Source: RBS Credit Strategy, Wikipedia 5 Half a century of credit supercycle
$tn US GDP 70 US credit market debt European credit market debt
Financial crisis 60 Competition & credit control Big Bang (UK) Glass-Steagall Act repealed Quantitative introduced / Bretton Woods easing breaks down
50
40 ?
30 You are here
20
10
0 52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12
Source: RBS Credit Strategy, ECB, FRED, Bloomberg
6 Bank capital is at a record low Book value of equity / total assets for US banks
70%
60%
50%
40%
30%
20%
10%
0% 1834 1844 1854 1864 1874 1884 1894 1904 1914 1924 1934 1944 1954 1964 1974 1984 1994 2004
Source: RBS Credit Strategy, FDIC, Historical Statistics of America 7 1. Restarting Europe’s credit engine
2. Fixing the banks (TLTRO, AQR, stress test)
QE
3. Boosting non-bank lending (Credit Easing with ABS) 4. The exit show: QE, asset bubbles, macro-pru for the US and UK
Source: Google. No animals were harmed during the making of this slide 8
1. Restarting Europe’s credit engine
QE
Source: Google. No animals were harmed during the making of this slide 9
The credit cycle: Europe stabilising, US re-leveraging, EM crunch
A cycle of four phases Bubble Crunch 1. Crunch GDP↓↓, π↓↓, D↑↑, M&A↓↓ 2. Stabilisation GDP↓, π↓, D ↓↓, M&A ↓ 3. Re-leveraging GDP↑, π ↑, D ~, M&A ↑ 4. Bubble GDP↑↑, π ↑↑, D ~, M&A ↑↑
GDP = real growth π = inflation
D = default rates M&A = M&A activity Re-leveraging Stabilisation
Source: RBS Credit Strategy, Bloomberg
Europe is stabilising, the US re-leveraging, EM are in an early crunch
10 Still the largest banks in the world
700% Bank assets % GDP 10-years ago
600%
500%
400%
300%
200%
100%
0% UK US Italy Spain GIIPS Japan Ireland France Austria Cyprus Finland Norway Canada Sweden Slovenia Australia Denmark Germany Euro Area Euro Switzerland
Source: ECB 11 Banking systems: Euro area vs US Euro area US 6,790 - Number of banks - 5,783
3.1x - Bank assets/GDP - 0.8x
37 - Number of branches - 35 per 100,000 adults
22% - Bonds/total debt - 52%
16% - Mkt share of top 5 banks - 33%
€1,041bn -NPLs-$200bn
10.9% -NPLs/GDP -1.2% Source: RBS Credit Strategy, Bank of Italy, ECB, IMF, World Bank, FRED 12 The good news: Bank deleveraging is stabilising Deleveraging has stabilised: monthly total asset deleveraging in the eurozone, €tn
0. 0
-0.5
-1.0 -0 .6 +0.3-0 .3 -0.2 -1.5 +0 .1 +0. 2 -0 .6 0.0 -2.0 +0.1 -0.1 -2.5 -0.6 -0 .4 -3.0 -0.5 -3.5 -0 .3 -0.2 -0.1 -0.02 +0.4 +0.2 -4.0 -0.03 -0.1 -4.5 -0.2 -4.1 -0.9 -5.0 Jun-12 Dec-12 Jun-13 Dec-13 Total
Source: RBS Credit Strategy, ECB 13 The problem: Financial fragmentation is still high Unemployment rate and growth gap between core and periphery continues to widen
The funding gap The employment gap The solvency gap SME average loan rates, % Unemployment rate, % Non-performing loans, %
8% Periphery 20% 20% Periphery Core Periphery Core Core
16% 15%
6%
12% 10%
5% 8% 5%
3% 4% 0% 07 08 09 10 11 12 13 14 07 08 09 10 11 12 13 14 07 08 09 10 11 12 13 14
Source: RBS Credit Strategy, Bloomberg Source: RBS Credit Strategy, Bloomberg Source: RBS Credit Strategy, Bloomberg
Financial fragmentation impairs the transmission mechanism of monetary policy
14 The bank job: Fixing Europe’s banks
Source: Google. No banks were harmed during the making of this slide 15 Lessons from the crisis
20% Losses as % initial loans Losses as % initial assets
15%
10%
5%
0% ML BoI AIB B&B SNS UBS NBG Anglo Dexia Amag Wach Nrock Monte HBOS WaMu Bankia
Source: RBS Credit Strategy, ECB, Bloomberg 16 Lessons from the crisis
20%
15%
10% average loss for bad banks
5% 3% requirement
0% CS DB KBC UBS BNP ABN BBVA Intesa Lloyds CMZB Nordea Danske Barclays Soc GenSoc Unicredit ING Bank ING Rabobank Santander Credit Ag Group Ag Credit
Source: RBS Credit Strategy, ECB, Bloomberg 17 Capitalism without capital The inverse relationship between RWA % (Y) and bank size, €bn (X)
100%
90%
80%
70%
60% BBVA 50% UniCredit Intesa S ant ander HSBC 40% Rabo ING Lloyds BPCE BNP 30% LBBW ABN Danske CS 20% SEB Nordea Soc G en Barclays Credit Ag Deka Nwide SHB DZ Natixis UBS 10% Poholja DB
0% 0 200 400 600 800 1,000 1, 200 1,400 1, 600 1,800 2, 000
Source: RBS Credit Strategy, Bloomberg, company filings 18 Too big to fail has not gone away Bank assets % GDP
200% 180% 160% 140% 120% 100% 80% 60%
40% 20%
0% CS DB Citi GS MS UBS SEB KBC BES RZB JPM BAC BNP HSBC D anske SocGen Barclays Unicredit Credit Ag ING Bank ING Rabobank Santander
Source: RBS Credit Strategy, Bloomberg 19 Interconnectedness: Cross-holdings in Europe’s banking system
Italy
4.5% 8.2% 100% Qatar Iberdrola JP Morgan Toro Generali
1.3% 1.4% Abu Dhabi Libya Veolia 2.5% 12.5% 6.5% 2.6% Intesa 3.7% Monte 5.16% BlackRock 4.9% Gr oupama Mediobanca UniCredit 8.7% 0.15% 2.45% Germany 2.4% France 3.5% 2.5% Credit Agricole SocGen Mediolanum 17% Allianz 1.0% 1.4% 10.8% AXA 1.0% 0.06% BES 4.1% 0.03% 10.1% Portugal Telecom 6.0% Natixis AM POP 6.9% Deutsche Bank Commerzbank 0.16% BBVA 1.3% 1.7% Caixa Geral 4.5% 0.12% 4.76% 1.3% 3.9% 5.75% 1.7% 0.5% Credit BNP 2.8% Santander UBS CRH Suisse Caixa Telefonica Holdings 4.0% 6.4% 5.6% 3.2% 1.6% 0.41% 35% Caixabank 12.21% Norway Singapore Gas Natural Repsol Bankinter State Street
Source: RBS Credit Strategy, Bloomberg, company filings. Red = bank, Grey = sovereign, Blue = other 20 Costs are still high Number per 100,000 population, in Italy
80
70
60
50
40
30
20
10
0 Museums High schools Secondary Primary Pharmacies K indergart ens H otels B ank schools schools branches
Source: OECD, Bloomberg 21 A two-tier banking system Return on equity vs credit rating (bubble size indicates amount of total assets)
RoE PLC Investment banks Cooperatives/Savings banks 20%
15%
10%
5%
0%
-5%
-10%
-15% AA A BBBBB B CCC
Source: RBS Credit Strategy, Bloomberg
22 Stress test: Mid-sized banks vulnerable to rising NPLs and bond spreads
Bank CT1 ratio after estimated NPL shocks, and widening of sovereign bond yields over 3 years under EBA’s adverse scenario
26% CT1 loss on non-periphery sovereign widening (aft er earnings and dividends)
24% CT1 loss on periphery sovereign widening (aft er earnings and dividends) CT1 loss on NPL rise, 50% coverage rat io (af ter earnings and dividends) 22% Earnings (80% of 3y PPI net of cash dividends) 20% CT1 capital af ter st ress, before earnings + = Capital after the exercise 18% at risk
16%
14%
12%
10%
8%
6%
4%
2%
0% DB IKB BPI AIB SID UBI RBI RL B NL B BES BCP RZB OVB SHB KBC HSH SEB BNP BMN NBG WGZ BKIR Erste Jyske ABLV Alpha BPER BCEE BPCE Ll oyds HSBC Int esa Aareal BBVA Carige CXGD LBWF RNW* Bawag NKBM CM ZB LBBW Bank ia Helaba Iccrea* CEISS CreVal Belfius Veneto Uni caja No rdea Pohjola Ibe rcaja Piraeus Popu lar Dansk e CredEm Nykred it SocGen NordLB* Arge nta* Sydban k Barclays Sabadell Popolare ApoBan k DZ Bank UniCredit DNB Nor DNB Bankinter BayernLB L iberb ank Euroba nk ING Bank ING BP Milano Catalunya DekaBank Ra boba nk Santand er BoValletta Crédi Mut t Swedbank Kutxabank SNS Bank SNS Caix aban k BP Sondrio BPI France Lan Berlin d Perm. TSB Perm. BP Vicenza C'mar/ BCC Med ioba nca NCG Banco ABN AMRO BkCyprus of Cred Ag Grp Ag Cred Munich Hypo Munich Hell enic Ban k Mo nte Pa schi Stronger Weaker Source: RBS Credit Strategy, company filings, Bloomberg, EBA. Sovereign holdings data is from the EBA, and is as of June 2013. Notes: We use FY 2013 results for the banks or the most recent filings available (marked with a *). We do not take into account measures to improve capital ratios post 31 December 2013. To translate the EBA’s adverse scenario into an NPL shock, we regress the change in NPLs over change in real GDP, unemployment and house prices during the crisis and adapt it to the EBA assumptions. If sovereign holdings data from the EBA is unavailable we use the national average. If EBA data is not available for any bank from a country, we use the periphery or core average, depending on the bank’s location. We stress the AfS and HfT portfolios of banks only, proxied as 70% of gross direct long positions. 3y PPI is 80% of average pre-provision income in 2011-13 less 80% of average cash dividends paid over 2011-13, as % of RWAs; The capital ratios are measured against each bank’s own reporting standards, typically Basel 2, 2.5 or the German Solvency standard for the Landesbanks (note the EBA tests will use transitional CET1 ratio definition under CRR/CRD). IKB and Belfius have negative earnings so we reduce remaining CT1 capital to adjust for this. The EBA will use 8% and 5.5% capital threshold for its baseline and adverse scenario of the stress tests. The above sample has banks which are included in the EBA’s sample list: the EBA list has roughly 25 more banks than our current sample. The weak German banks in our test have reasonable initial capital 23 levels, but lose out due to high holdings of bunds.
Stress test: The bottom 30 in our adverse scenario simulation
24% + CT1 loss on non-periphery sovereign widening (after e arnings and dividends) 22% = capital CT1 loss on periphery sovereign widening (after earnings and dividends) after the 20% CT1 loss on NPL rise, 50% coverage ratio (after earnings and dividends) at risk exercises 18% Earnings (80% of 3y PPI net of cash dividends) 16% CT1 capital after stress, before earnings 14% 12% 10% 8% 6% 4% 2% 0% IKB RLB BES NBG BMN WGZ BPER LBWF RNW* CXGD CEISS Belfius Carige Iccrea* CreV al Helaba Veneto CredEm Nykredit NordLB* Popolare UniCredit BP Milano BPI France BPI BP Sondrio BP Vicenza BP C'mar/ BCC C'mar/ Munich Hypo Munich Hellenic Bank Hellenic Monte Paschi Monte Stronger Weaker
24 The economics of a TLTRO loan
35 TLTRO cost SME loan RWA is Loan yield = 3% = 0.25% 75% (8% capital 30 charge) 2% default rate, 25 40% recovery
20 Normal funding Savings cost = 1% = 0.75% 15 0.5% c os t
10
Based on a €1,000 loan loan a €1,000 on Based 0.6% RoA
5
0 Gross interest Normal TLTRO Cost of capital Cost of Fixed costs Net interest income funding costs savings on loans provisions income
Source: ECB, RBS Credit Strategy estimates
25 TLTROnomics: Boosting profitability but not if default rise Return on equity of a TLTRO-funded loan for a given default rate, %
45% Core bank (lending at 3%) 40% Periphery bank (lending at 5%) 35% 30% 25% 20% 15% 10%
Return on Equity 5% 0% -5% Economic break-even default rates 1% 2% 3% 4% 5% 6% 7% Annual default rate
Source: RBS Credit Strategy 26 €4.1tn Deleveraging by Eurozone banks so far €1tn Further deleveraging we think is needed 70% Of that will come from small banks
30% Will come from large banks €374bn Decline in non-fin corporate loans so far
€29bn Capital needed by large European banks
We assume that 80% of capital requirements will be met by raising fresh capital or through earnings for large banks, and 20% from shrinking assets. For small banks, we assume 60% of capital requirements will be met by raising fresh capital or through earnings, and 40% from shrinking assets. 27 A formula for financial stability
Crisis bank size of =[ -(capital + bail-in + backstops)] x cost losses system
banks lost €55bn 3% 8% of 3x GDP 2%-13% of leverage ratio total liabilities SRM fund total assets in previous crises
= 5.8% capital / assets
Source: RBS Credit Strategy, BBG, Company filings 28 Cocos: are you a lover or a hater?
QE 1. I am buying them for yield 2. I think conversion risk is unlikely 3. I am buying them because of lack of alternatives 4. I think they are fundamentally cheap 5. I will never buy them!
Source: Google images, Marmite 29 Contingent capital: A solution or the beginning of a new problem? Yield is the top reason why people buy cocos, despite heavy losses expected upon trigger event
Investors are searching for yield …but do expect a steep drop when a conversion occurs Why are you buying cocos? How do you think the market will react to a conversion?
80% % answers 70 Avg expected drop: -15% 70% 60 60% 50 50% 40 40% But high 30 tail risk 30% 20 20%
10% 10
0% 0 Y ield Co nversio n is Lack of Cheap vs risks 0-2-4-6-8-10-12-14-16-18-20 unlikely alt ern at iv es Coco market price drop following a conversion
Source: RBS Credit Strategy Source: RBS Credit Strategy
Investors are calling for greater standardisation from regulators
30 3. A new financial world: Boosting non-bank lending
Source: The Economist 31 What will the ECB do? CE, not QE is the game changer for credit
Refi rate cut
Forward guidance Liquidity easing LTROs Negative deposit rates FX reduction QE Credit easing (buying ABS) Potential game-changers Credit easing (buying bank loans)
32 Closing the gap: New funding sources can offset loan deleveraging
0
-5 0
-100 +50 -150 -154 -200 +80
-250 +40
€bn -300 +50
-350
-400 -374 Decline in NFC Annual growth in New CLOs and Fres h EIB Non-bank Net financing loans since HY bond market securitisations lending lenders gap May 2012
Source: ECB, RBS Credit Strategy estimates
33 4. The exit show: QE, asset bubbles and collateral effects for US and UK banks
Source: Google images 34 Which asset class is already in a bubble?
QE 1. Long-term Treasuries and Gilts 2. US high yield and leveraged loans 3. UK property 4. Periphery bonds 5. Technology stocks 6. Coco bonds 7. Bubbles, bubbles everywhere! Source: Google images, Marmite 35 “Now, back to Macro. What is your exit strategy? The players won't be in on the scam, so they'll all think it's their lucky night, but you'll never get them out of there with their winnings, they'll gamble it all back. That's Vegas and that's your problem.” Roman Nagel, Ocean’s Thirteen
Source: Google images 36 US labour markets back to (a different) normal
Source: RBS Credit Strategy, BLS Source: RBS Credit Strategy, Atlanta Fed 37 The Pruman Show: Macro-pru and microwave risk in the UK Microwave risk can turn bondholders into popcorn
BoE: loosest policy in 320 years London calling – a bubble UK Bank of England Bank Rate, % Change in house prices since 2007
18% UK Bank Rate 16%
14%
12%
10%
8%
6%
4%
2%
0% 1700 1750 1800 1850 1900 1950 2000
Source: RBS Credit Strategy, Bank of England Source: RBS Credit Strategy, HM Land Registry
38 Getting out of the leverage trap will hurt UK consumers
Disposable income (£) A small 25b p rate hike 1 year from now wo uld only 24,000 reduce disposable income by £320 (-1.5%)
22,000 W e are here If Bank Rate goes to 4% disposable income would fall b y £5,000 (-21%) 20,000
18,000 80% LTV
16,000 But for borrowers with a 95% mortgage the decline is 14,000 £5,800 (-28%) 95% LTV
12,000 0% 1% 2% Bank Rate 3% 4% 5%
Source: RBS Credit Strategy, ONS, Bank of England. Assuming house price to income of 4.6x for the 80% LTV mortgage and of 5.2x for the 95% LTV. 39 “The positive news is the British economy is continuing to grow and is creating jobs. And it is positive news that at a time of international instability we are a safe haven in the storm.” - George Osborne, Chancellor of the Exchequer, July 2011
“A healthy housing market is good for our economy and will help to support the recovery [...] But let's not be naive. Anyone with more than a passing interest in British economic history is aware that the UK housing market has a sort of microwave type quality to it, with a tendency to turn from lukewarm to scalding hot in a matter of a few economic seconds.” - Spencer Dale, MPC Member, April 2014
40 Conclusions
QE
1. Europe is on a trajectory of structural improvement to bank/credit markets 2. Banks still need more capital and will take time to lend again, despite TLTRO 3. But European policymakers are on the right path: credit easing (CE) with ABS is a real game-changer 4. The US and UK exit will be more problematic, with high popcorn risk
Source: Google images. No animals or planets (only banks) were harmed for the making of this slide 41 © Copyright 2014 The Royal Bank of Scotland plc and affiliated companies ("RBS"). All rights reserved. This Material was prepared by the legal entity named on the cover or inside cover page. It is provided for informational purposes only and does not constitute an offer to sell or a solicitation to buy any security or other financial instrument. While based on information believed to be reliable, no guarantee is given that it is accurate or complete. While we endeavour to update on a reasonable basis the information and opinions contained herein, there may be regulatory, compliance or other reasons that prevent us from doing so. The opinions, forecasts, assumptions, estimates, derived valuations and target price(s) contained in this Material are as of the date indicated and are subject to change at any time without prior notice. The investments referred to may not be suitable for the specific
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