Tuesday, February 16, 2010

Banks Elevated Sovereign Funding Costs and European Banks

Elevated sovereign funding risks pose multiple threats to European bank stocks and we downgrade our sector view back to a “cautious” vs. index (as well as downgrade ratings on SAN, BBVA, Piraeus and EFG). We see five key risks: (i) funding costs materially higher, particularly in Southern Europe, hurting NII, while lower-for-longer rates postpone improvements in liability spreads. We estimate €3.3tn in total wholesale funding, of which ~48% could roll over 2010-12; (ii) loan growth to be challenged; (iii) provisions likely to rise from tighter conditions and some MTM losses; (iv) higher tax rates likely; and (v) higher costs of equity. We also see the risk of regime change from “managed deleveraging” to “accelerated deleveraging” with risks to bank stocks, credit markets and economies.

What’s in the price. We think the market implies ~14.2% 2011 returns from bank stocks on an ~11.5% cost of equity vs. our bottom up base case returns of 8.7% in 10e, 13.3% in 11e and 16.2% in 12e. We run a harsher scenario analysis that see returns fall ~2.4% (or prima facie take ~23% off price targets). We also recently argued bank regulation could shave ~1.5% off
returns before modification. Given our view that elevated sovereign spreads are likely to persist, risk/reward skew and uncertainty, we expect investors will anchor on nearer years and in tandem with our European strategists we downgrade the banks sector to UW vs. the index and see better value in US and EM banks.

Recommendations: We’ve factored higher sovereign risk into our cost of equity & revised views on returns and NPLs for a large number of banks. We would switch out of BBVA and SAN (cut to EW) into our best ideas: CSG, GLE, BNP (upgraded to OW), Baer, SHB, BARC, KBC, ISP or SDR. Least preferred: DX, RI, CBK, SEB, DPB, Piraeus (cut to UW), BKT, BME & LSE.

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