Life hasnt been easy for Europes banks over the last four years. In August 2011, it got even tougher. As financial market conditions worsened over the summer, with sovereign bond investors deserting Italy and putting the entire European project at risk, the continents financial institutions once again bore the brunt. The EuroStoxx banks index had lost half its value in the year to the beginning of September.
"The number one concern on investors minds is the broader macroeconomic environment and the short to medium term impact on underlying business. Thats first and foremost," says Neil Kell, head of EMEA financial institutions ECM at Deutsche Bank in London
For Craig Coben, head of EMEA equity capital markets at Bank of America Merrill Lynch, investors in bank stocks are no longer interested in individual equity stories its the eurozone that matters. "Macroeconomic considerations have completely dominated sentiment," he says. "Investors have moved away from a bottom-up analysis and are really trying to assess the way in which the macroeconomic imbalances in the eurozone are going to be resolved. Theyve taken their cue from the bond market, theyve taken their cue from the politicians, and it is making it very difficult to engage in fundamental bottom-up analysis of stocks."
European banks were trading at an average price to book value of around 0.6 times in late August still off the lows of March 2009 when they plumbed the depths at 0.44 times but not a price at which any bank board will be thanked for raising equity. The cost of capital has risen fast, says Emmanuel Pezier, head of FIG equity capital markets at UniCredit in London.
"With a weakening outlook for most European economies, and higher capital requirements, the simple truth is that banks will find it harder to make returns going forward," he says. "There is likely to be less demand for loans, higher NPLs, a fight to hold on to deposits and cut-throat competition in investment banking. Meanwhile, the cost of debt is at very elevated levels for most banks, if they can fund at all. Net issuance year to date is basically zero with banks just about raising enough to cover maturities the recent spate of covered bonds shows how keen banks are to hit any windows while theyre open. And equity markets dont look much better. People are waking up to the chance London may not see any more IPOs this year. And rights issues involve long at-risk periods and deep discounts. Put that all together and many banks are in a monumental struggle just to earn in excess of their cost of capital."
The eurozone crisis has already added to that burden. Private sector involvement in Greeces latest bail-out crisis will see many European banks take 21% writedowns on their holdings of the sovereigns bonds. For non-domestic holders, that is not a disaster but it has brought into focus the potential for deeper and more sweeping writedowns on other sovereigns unless a solution can be found.
"If haircuts remain at the Greek level then OK, it is manageable, the only banks at risk will be Greek banks" says Alex Koagne, a European banks analyst at Natixis in Paris. "But the fact is that banks dont hold capital against their exposure to sovereign debt. The probability of default under Basel II or Basel III is 0%. Banks do not have the capital to weather any kind of losses on sovereign debt."
And that leaves investors concerned. Very concerned. After all, if haircuts were extended to some of the larger sovereign issuers, or if the eurozone itself were to break apart, banks would find themselves in need of much, much more capital.
"There is a non-negligible chance of a European sovereign default at some point," says Pezier. "The extreme volatility were seeing is the result of investors trying to price in the risk and effects of such an event. When you bear in mind that banks dont risk-weight their sovereign bonds, its hard to see how a bank can continue to function if the country in which it operates goes bust. Sovereign default is a slow-burner."
He points to the share prices of Greek and Irish banks to show the long-term effect. " Equity investors are getting creamed."
The stress tests conducted by the European Banking Authority in July showed exactly what the continents banks are up against. They didnt explicitly test for resilience to widespread sovereign losses leading some commentators to criticise the tests as too weak but they did make banks reveal their cross-border corporate and sovereign exposures.
That allowed analysts to run the numbers themselves simulating greater than 21% losses on Greece, for instance, or asking what would happen if Portugal or Ireland or even Spain or Italy joined the haircut club.
So while few banks failed the stress tests themselves, many more looked weak given a modest ratcheting of the eurozone sovereign debt crisis scenarios. But what can those banks do to regain the confidence of investors? Very little, it seems. Until the eurozone problem is solved until at least there is transparency as to its potential resolution private investors will have almost no appetite to put fresh capital into banks at anything other than terms no existing shareholder could stomach.
As Coben says, there needs to be a resolution of the eurozone stresses. "The fundamental question is being asked of the currency union: what is the support that the euro periphery has from the euro-core and what are the conditions attached? Its very difficult to convince investors to provide funding and to inject capital into banks when they dont know the answer."
At Natixis, the view is that the only short term solution is for the issuance of bonds jointly and severally guaranteed by the eurozone members. The confusingly named Eurobonds would at a stroke remove liquidity risk from the periphery and allow other markets to function properly.
"Its the only way to get out of the crisis in the very short term," says Koagne. "Before the situation changes, before banks can sell assets, raise equity or decrease the cost of funding, the pre-requisite is that the sovereign crisis in Europe ends. It is simple: if you dont find that global solution to the sovereign crisis, banks, which own 40% of eurozone sovereign debt, will remain under pressure."
If its not Eurobonds then it must be something similar. "You need good macro newsflow that will give to the market the feeling that the European countries can deleverage and improve the quality of their finances. If you have that, the funding pressure will decrease and you have a better EPS world and therefore better capital generation. That is the dynamic you first need to work on the sovereign crisis."
As of the time of writing in early September, with European governments still arguing about terms they were supposed to have agreed in July for a limited expansion of the European Financial Stability Mechanism (EFSM) that possibility remains remote.
But some banks will need capital before a final agreement can be reached.
"The question now is which banks are viable enough to raise equity and which banks arent. There is a subset of banks which could have raised equity a few months ago and will probably now find it very difficult to raise equity or at least to secure the underwriting support of banks," says Coben. "Its not just a question of asset quality; its also a question of the sovereign support. It means that in some cases banks which have been relatively well managed may find it more difficult to raise equity than banks which have been less well-managed simply because they happen to be in a different geography."
Indeed, any bank coming to the market for equity in the remainder of the year will find terms are much tougher. Discounts will be bigger, which while it has no impact on the economics of a deal it can be difficult for boards to swallow. After narrowly escaping from losses on a 1bn deal for Italys UBI Banca in June, underwriters are in no mood to negotiate.
"It was amazing how quickly people forgot about tail risk in rights issue underwriting," says Coben. "It is real risk. People were increasing transaction risk out of a kind of macho desire to have a narrow discount, and thats just daft. Its not even as if people remember the discount. Some of the most successful rights issues during the financial crisis had very deep discounts to TERP, and so what are we trying to prove?"
"Nobody wanted to come with a much wider discount than the deal that came before for their close competitors," he says. "So by the time we got to the fourth or fifth deal, it was more challenging to independently assess pricing. Markets had moved and those deals set the tone. That said, every situation is different and has a different shareholder base."
That kind of thinking will have to change if banks are to get deals away from now on.
"Terms will need to be more favourable to investors but I dont think weve reached a stage where the market is saying weve come to the end of the road," says Willem-Jan Meijer, global head of equity capital markets at ING Commercial Banking in Amsterdam. "We might reach that stage for certain issuers at some point if we go into fully-fledged recession and the eurozone crisis worsens balance sheets will need significant strengthening all around but I dont think were there yet.
"With the right terms and structure, which will include anchor investors in some instances, these deals could still get done."
Weak plus weaker equals stronger?
Even so, it will be tough and banks will need to be creative. "Given the volatility of the market and the downward trend, it is very difficult for banks to raise capital in this market," says Koagne. "So the only way to improve a capital ratio is to reduce RWAs."
Asset sales are one way to do that but only if a price can be achieved that results in capital being freed up, not destroyed by loss-making sales.
"Valuations arent helping," says Meijer. "A sale needs to make sense in order to free up capital. But with valuations coming down so rapidly, its not attractive. Also, national authorities are worried about shrinking balance sheets and the effect that will have on the availability of credit to the local economy. In that sense some of the more pan-European banks might be under pressure to draw back into their home countries. Overall, that would make fewer alternative sources of financing available and put pressure on pricing."
Koagne says the situation means that banks have no option but to sit it out.
"Many European banks need or want to sell non-core or non-strategic assets," he says. "But assets that were worth two times book value in 2006 are now worth just 0.5 times or 0.7 times book value. It is really difficult to find buyers for these assets. The market is not shut, but almost shut for those kind of assets. The only thing banks can do right now is wait and see if market conditions improve."
Others see a glimmer of possibility. Meijer says that banks are looking at a wide range of different options. "They are considering, should it come to the worst, how to monetise assets, come up with new structures or find anchor-type investors."
The tie-up of Greeces Alpha Bank with EFG Eurobank is a case in point although the merged entity is by no means strong, it should be able to cut out enough costs including paying less for deposits given its market share to be able to attract external money. Qatars Paramount fund is putting up 500m and another 1.25bn should come from a rights issue if it can survive into next year when the deal completes.
"What were seeing now in Greece with Alpha/EFG, or in Spain with the savings banks mergers, is a likely outcome for more countries banks to grow bigger and absorb weaker partners and take care of their capital needs that way, while making the story more attractive from a capital markets perspective," says Meijer. "That will initially be a local phenomenon, driven by local central banks, though it could also become cross-border.
"From a capital markets perspective, certain banks would need to be more attractive for them to raise capital and this is one of the routes to get there. Its still not highly attractive but more digestible and more attractive and the best thing to come along."
All this leaves Basel III and the drive for banks to hold more capital on hold.
"Its not at the top of peoples agenda right now," says Coben. "The focus has really shifted to what the European authorities are going to do to hold together the eurozone and whether monetary union is a limited liability or a joint-and-several liability enterprise."
Its a widely shared opinion. Meijer says the state of the economy is all-important. "There is a strong sense that if we are really heading into a recession, that the eurozone crisis will continue, then Basel III will be delayed. We face different issues."
There were already signs of this halt on Basel before the summer as national economies began to move at different speeds and with them, regulators.
"A year ago we were all anticipating a very cohesive systematic approach to all European banks," says Kell. "Instead of looking at Spanish banks or Nordic banks or UK banks, lets look at European banks and determine the appropriate level of capital, then adjust depending on size and other parameters. But what weve seen actually develop over the last 12 months has been somewhat of a region-by-region approach, whether that is regulatory decisions or just views on banks by investors. Of course regulatory bodies are doing their best to create system-wide solutions but its not easy."
He says that are very few industries which have such a high correlation to their national economy. "Banks are almost perfectly correlated to the underlying economic environment in which they operate. The national economy is the main driver of those businesses and the underlying profitability and, frankly, even the funding, because a lot of the funding markets are local."
Regulators are also now appearing to wake up to the importance of not imposing too strict a regime on their charges. With governments across the continent engaging in austerity, removing a key prop of aggregate demand, the need to have banks able and willing to keep credit flowing is all the more important.
In August, Andrew Haldane, executive director for financial stability at the Bank of England, indicated that credit conditions had reached a point where a loosening of policy might be necessary. That theme could well play out further over the coming year.
"Although Basel III will still be in our minds, the main focus will be on keeping the banks capitalised to run their businesses" says Meijer.
The tragedy of the eurozone crisis is that the banking industry has come a long way since 2008 doubling the level of common equity capital, cleaning up troubled assets and providing a much higher level of transparency as they work within tighter regulatory regimes. But it hasnt gone far enough certainly not far enough to cope with the sovereign mess.Pezier reckons that banks in Europe need something like 100bn of fresh capital. "Some will still be able to do so in the equity market, but until the sovereign issue is resolved investors will demand very high risk premia," he says. "The cost of equity will be very high, reflected in historically low price to book multiples. Those that cant raise equity in the public market may be nationalised. Its depressing, but probably realistic."