ANALYSIS-Europe’s banks loath to jettison cash ballast for returns

August 13, 2010

By Steve Slater

LONDON, Aug 13 (Reuters) – Some of Europe’s banks are faced with the unusual problem of holding too much cash as they try to lift sluggish returns, and few will dare to eat into capital until well into 2011 amid an uncertain regulatory outlook.

A jump in profits may have prompted banks like HSBC and Barclays to talk about improving returns for investors, but the financial crisis is too fresh in the memory for regulators and bank bosses.

“It’s still too early. Returns have been pushed down by the capital, but even though Basel III has been pushed out and watered down there’s still a nervousness at being seen to do anything other than build your capital,” said Chris Wheeler, bank analyst at Mediobanca.

“I think that will certainly go into next year.”

HSBC, the biggest bank outside China, is holding more capital than at any time in the last 20 years.

That creates a big drag for its return on equity (RoE), a key measure of efficiency at making profit from the resources provided by investors. HSBC’s RoE was 9.3 percent in the first half of the year, well short of its target of 15 to 19 percent.

Barclays is another relative winner of the crisis, and like HSBC had to raise billions from investors to fatten up its capital cushion. Decent profits have swelled capital further and its RoE limped in at 9.8 percent in the first half, below its cost of capital.

Nordic banks such as Swedbank and SEB have healthy capital positions and are facing increasing scrutiny on when weak returns will improve.

“Assuming we don’t go back into a recession the level of capital banks have will prove to be too great in the not too distant future,” said Julian Cane, director of UK equities at fund manager F&C.

“But until the (capital) rules are set in stone, they are all anxious not to pay too much of it back to shareholders.”

New rules requiring banks to hold more and better quality capital will be finalised in November. The reforms are less harsh than early proposals, but will still force banks to have a core Tier 1 capital ratio of at least 8 percent — far above current minimum levels — banking industry and regulation sources told Reuters this week. [ID:nTOE67A07H]


Returns will improve as profits rise, but there will be no return to the lofty levels of the decade before the financial crisis erupted.

European banks’ average RoE was 18-23 percent between 2003 and 2007, compared to 12-15 percent in the mid-1990s, Citi analysts have estimated.

Returns are expected to go back to around 10-15 percent, analysts said. The leverage that drove returns higher for a decade is now being reversed as banks take fewer risks, added to by the impact of higher capital and depressed margins in a low interest rate environment.

UBS predicts European banks’ RoE will average 9.4 percent this year, 11.5 percent in 2011 and 12.9 percent in 2012.

CreditSights analysts are more pessimistic, saying Europe’s banks must get used to RoE of under 10 percent, adding: “We are not sure if the equity market has yet come to terms with this.”

Higher returns typically drive higher share price valuations: the RoE needs to exceed the cost of equity to justify a premium rating to book value. Higher funding costs are expected to keep the cost of equity relatively elevated.

UBS analysts estimated Europe’s banks trade on about 0.9 times next year’s estimated book value, compared to about 1.7 times for Asian (ex-Japan) banks and 1.1 times for U.S. banks.

In terms of RoE, Europe’s banks lag rivals everywhere except the United States and Japan. Average RoE next year for banks will be 18.8 percent in Asia (ex-Japan), 18 percent in Canada, 21.8 percent in Latin America banks and just 8 percent in the United States, UBS estimated.

Laggards in Europe include Italy’s UniCredit and Intesa and France’s Credit Agricole, all with an RoE of under 6 percent.


Banks are well aware of the problem. HSBC said it will assess its target for returns later this year.

“It’s difficult for us to have a 15 to 19 percent RoE on a Tier 1 capital ratio of 11.5 percent,” HSBC Chief Executive Michael Geoghegan said last week. “I’m not saying we’re scrapping that target, just that we’re now aspiring to the lower end of it.”

Nordic banks built up capital earlier in the cycle than rivals and bad debts fell earlier too. They said there is no rush to reduce capital, but investors are fretting premium valuations will fade as returns get squeezed.

Swiss regulators seem in no mood to let UBS and Credit Suisse ease back from their capital build up, although their returns are among the highest anyway.

Local regulators are likely to dictate the pace that any bank can act.

Dividends may nudge higher after collapsing in the last two years, but substantial share buy-backs are not expected.

Cash rich banks could follow Santander, which has struck big deals in Britain, Germany and Mexico this year to keep growing. HSBC said having excess capital was handy if it spots a deal that could deliver returns of over 15 percent.

Banks will also shift their business mix, hunting for where returns are best. First-half results showed a wide divergence — not just in different parts of the world, but also between segments. UK retail banking generated far higher returns that corporate banking, for example.

Investors are wary of any short-term fix and say banks need to get the balance right.

“I would rather invest in a bank that does not play around with capital to plump up returns. I want to see banks that have a decent RoE, a good capitalisation that enables them to grow and I would like to see them positioned in markets where there is growth availability,” said Patrick Lemmens, manager of the Robeco New World Financials.

(Additional reporting by Cecilia Valente, Editing by Sitaraman Shankar)

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