Yesterday saw the equity valuation of European banks (the price/book ratio for the Euro Stoxx Banks Index) hit its lowest point (0.599) since 2 August 2012 (shortly after Draghi’s “whatever it takes” speech). This drop in equity valuations, particularly since the start of this year, reflects not only the general risk-off mood in equities, but also what appear to be growing fears around the health of the banking sector in Europe.
But while equity valuations have tanked, the move in CDS has been much less pronounced. European banks’ CDS is currently trading around 106, 30 points wider from the start of the year, but still a far cry from 280 level that was hit on 2 August 2012.
EUR Stoxx Banks Index vs. iTraxx SNRFINSource: Bloomberg
Of course bond investors now feel more confident for a number of reasons, including:
- a now-negligible risk of euro break up;
- a better macroeconomic backdrop;
- improved bank capitalisation;
- significant restructuring efforts that banks have undergone since 2012, and;
- better regulatory oversight. All of this should theoretically protect banks’ creditors.
Risk absorption metrics for European banks have improvedSource: European Banking Authority – Risk Dashboard
However, these positive developments must be balanced against:
- regulatory initiatives (e.g. Bank Recovery and Resolution Directive) that severely limit the use of state support in assisting bank recapitalisations;
- regulatory changes that allow losses to be imposed on banks’ senior debt outside of resolution, i.e. through bail-in;
- the unpredictability of the regulatory response to problems in the banking sector (e.g. the recent case of Novo Banco/Banco Espirito Santo), and;
- ongoing uncertainty around the true valuations of banks’ assets and any outstanding legacy issues (RBS’s surprise announcement regarding pension charges is a case in point).
More generally, perennially high impaired loans metrics continue to pose risks and leave banks very vulnerable to an economic downturn. As such, while we accept that CDS spreads should not be back at the highs seen in 2012, the current disconnect between CDS and equity valuations looks odd to us, not least given the fundamental changes in the regulatory framework in recent years (with more potentially to come).
Impaired loan ratio – European banksSource: European Banking Authority – Risk Dashboard