European Bank Stocks, Moral Hazard and Untangling Bank Regulations, Part II

Published April 19, 2021

Following up on last month’s piece, we’re going to put the theory to numbers with an example to illustrate the impact of capital rules and the various levers they apply on bank stocks. After that, we’ll look at a couple of European bank stock ideas. If you didn’t read the last post, I recommend you do that first.

Items to be covered in this post:

• Setting Up a Simple Two-Period Model to Understand the Multiple Variables
• Opportunities in European Bank Stocks: Long Side
• Opportunities in European Bank Stocks: Short Side
• A Note on Sizing and Timing
• Conclusion

Setting Up a Simple Two-Period Model to Understand the Multiple Variables

The best way to understand the interplay of banking rules is a simple example with a few scenarios. We can then see how various pieces work. I am not doing this to forecast what will happen, but to show some of the dynamics and how fluid things can be. 

Scenario 1: A Base Case

Let’s start on day 0 with the following balance sheet and potential earnings statistics for a hypothetical bank:

Balance Sheet at P=0

Now let’s assume a scenario (1) where there are no real bad loans in the period, and the bank does not increase its loans. The income statement and balance sheet for period 1 would look like this:

P&L	EUR
Interest Income	4+ 0.3 + 0.05 = 4.35
Interest Expense (-)	1.125 + 0.45 = 1.575
= NII	2.775
Operating Costs (-)	2.775 * 0.4 = 1.11
= Pre-Provision Inc.	2.775 – 1.11 = 1.665
Provisions (-)	80 * 0.004 = 0.32
= Pre – tax income	1.345

Balance Sheet at P=1

Assets	EUR		Liabilities + Equity	EUR
Loans	80 – 0.32 = 79.68		Deposits	75
Securities	15		Borrowings	15
Cash	5 +1.665 = 6.665		Equity	10+1.345= 11.345
TOTAL	101.345		TOTAL	11.345

I know the above is grossly oversimplified (there is now new loan growth, no fee and commission income, etc.).  From an accounting perspective in the above example, shareholders made a 13+% return. Not bad, right?

Now let’s think about this from the capital adequacy rules I talked about in the last piece.  Remember that banks have to have a certain amount of equity per unit of assets. For simplicity, I am assuming security and cash have a 0% requirement (no equity required), but that performing loans have a 50% risk weighting. Therefore, the capital adequacy ratio would be:

CAR @ T = 0	EUR		CAR @ T = 1	EUR
Loans	80		Loans	79.68
Weighting (x)	50%		Weighting (x)	50%
= Risk Assets	80 * 0.5 = 40		= Risk Assets	79.68 * 0.5 = 39.84
Equity	10		Equity	11.345
CAR	10 / 40 = 25%		CAR	11.35 / 39.84 = 28.5%

Under this example, the bank improved its capital adequacy ratio because it generated net income and its risk-weighted assets remained stable. 

Given that most CAR requirements in Europe are in the low teens, the bank looks in good shape and could maybe even return capital to shareholders. 

Scenario 2 – Introducing NPLs

In a second scenario, we are going to introduce the element of bad loans. We will assume that a certain % of loans will go bad during the period.  This means that the bank will need to provision more for such loans from income and that those loans’ income will be fully provisioned. This new scenario is reflected in the chart below. I have grayed areas where things have changed.

Balance Sheet at P=0

Assets	EUR		Liabilities + Equity	EUR
Loans	80		Deposits	75
Securities	15		Borrowings	15
Cash	5		Equity	10
TOTAL	100		TOTAL	100
Interest Rates
Loans	5%		Deposits	1.5%
Securities	2%		Borrowings	3%
Cash	1%
Cost to Income %	40% (Cost level is fixed)		Cost of Risk for performing loans	40 bps (0.4%)
			Cost of Risk for NPL	20%
			% NPLs	5%

The P&L and balance sheet evolution will look like this:

P&L	EUR
Interest Income	4.35
Interest Expense (-)	1.575
= NII	2.775
Operating Costs (-)	2.775 * 0.4 = 1.11
= Pre-Provision Inc.	2.775 – 1.11 = 1.665
Provisions (-)	75 * 0.004 + 5 * (0.2 + 0.05) = 1.55
= Pre – tax income	0.115

Balance Sheet at P=1

Assets	EUR		Liabilities + Equity	EUR
Loans	75 – 0.3 + 5 – 1 = 78.7		Deposits	75
Securities	15		Borrowings	15
Cash	5 +1.665 – 0.25 = 6.415		Equity	10 + 0.115 = 10.115
TOTAL	100.115		TOTAL	100.115

Notice how a 5% default and 20% provision (plus interest) on bad loans wipe out profits on the year. As we’ll see below, It also reduces the CAR ratio in period 1. As an additional assumption here, we will assume a 100% weighting for the unprovisioned portion of NPLs.

CAR @ T = 0	EUR		CAR @ T = 1	EUR
Loans	80		Loans / NPLs	74.7 / 4
Weighting	50%		Weighting	50% / 100%
Risk Assets	80 * 0.5 = 40		Risk Assets	74.7 * 0.5 + 4 * 1 = 41.35
Equity	10		Equity	10.115
CAR	10 / 40 = 25%		CAR	10.115  / 41.35 = 24.46%

As we can see, our capital adequacy is reduced in this scenario despite actually being profitable.  We’ll come to this again at the conclusion of this section, but it’s important to remember.

 

Scenario 3: Making Things More Like Europe

For this last scenario, I will adjust interest rates to current European levels and assume the same 5% NPL shock. The other piece is that the operating costs will be fixed nominally vs. scenarios 1 & 2.  I have grayed the components where things have changed in comparison to scenario 2.

Balance Sheet at P=0

Assets	EUR		Liabilities + Equity	EUR
Loans	80		Deposits	75
Securities	15		Borrowings	15
Cash	5		Equity	10
TOTAL	100			100
Interest Rates
Loans	3%		Deposits	0.25%
Securities	0.5%		Borrowings	1.5%
Cash	0%
Cost to Income %	40% (Cost level is fixed)		Cost of Risk for performing loans	40 bps (0.4%)
			Cost of Risk for NPL	20%
			% NPLs	5%

The P&L and balance sheet evolution will look like this:

P&L	EUR
Interest Income	2.4 + 0.075 + 0= 2.475
Interest Expense (-)	0.1875 + 0.225 = 0.4125
= NII	2.0625
Operating Costs (-)	1.11 = 54% C to NII
= Pre-Provision Inc.	2.0625 – 1.11 = 0.9525
Provisions (-)	75 * 0.004 + 5 * (0.2 + 0.03) = 1.45
= Pre – tax income	-0.4975

Balance Sheet at P=1

Assets	EUR		Liabilities + Equity	EUR
Loans	75 – 0.3 + 5 – 1 = 78.7		Deposits	75
Securities	15		Borrowings	15
Cash	5 +0.9525 – 0.15 = 5.8025		Equity	9.5025
TOTAL	99.5025		TOTAL	99.5025

So the topline NII was lower due to the interest rate dynamics, and the provisioning on 5% of the NPLs wiped out the profitability. What about the CAR?

CAR @ T = 0	EUR		CAR @ T = 1	EUR
Loans	80		Loans / NPLs	74.7 / 4
Weighting	50%		Weighting	50% / 100%
Risk Assets	80 * 0.5 = 40		Risk Assets	74.7 * 0.5 + 4 * 1 = 41.35
Equity	10		Equity	9.5025
CAR	10 / 40 = 25%		CAR	9.5025  / 41.35 = 22.98%

Notice that the only change vs. scenario 2 is the equity in the lower right. The bank’s profitability impacts the ratio just as much as the NPLs.

Scenarios vs. Reality: A Summary

From above, we can see a couple of critical variables:

• Net interest margins matter. In Europe, they have been declining for over a decade and do not look to be changing direction. This means earnings power is decreasing, which hinders a bank’s ability to create equity.
• A discrete jump in NPLs has a strong one-off impact on profitability and CAR’s, especially if that increase is more significant than the margin on loans. It turned a 10% return on equity into zero.
• We did not delve into it here, but when NIMs are low, it is difficult to grow one’s balance sheet after an NPL hit. The hit to CAR reduces the capacity to lend. Usually, when such hits happen, it is coincidently difficult to find willing borrowers.

As mentioned, these scenarios are overly simplistic. There are a couple of essential things I did not try to model that one should think about:

• Banks earn fee and commission income which is only partially linked to assets and can be a third of interest income. It helps increase pre-provision income without the risk of impairment. We all know how much banks love fees! That said, I think there is a limit to how much things can increase. Payment processing, which is big for many large banks, should decrease on a unit basis going forward.
• In the model above, I assumed a 20% provision of the loan principal after a loan was classified as an NPL. This is perhaps a high figure for a year, but most NPL’s are typically covered between 33-90% of the gross amount eventually, depending on the loan type. Banks often provision over time for loans that went bad years ago. This is a drag on other portfolio earnings when the loan goes bad and over time.
• Loans can always be restructured and eventually reclassified from an NPL to a regular loan. This reduces the risk weighting for the loan and allows the loan to start accruing interest. 
• Risk weightings are done either on a standardized basis set by the regulator or imposed by the bank itself with regulatory approval. The latter is based on historical analysis. The bottom line is that, like all models, there are flaws with either approach. With the current levels of profitability, however, there is a lot less room for error. 
• We did not cover liquidity ratios here. They drag on profitability because they force banks to hold lower-yielding liquid assets. These are also based on the historical data to simulate a run on the bank. This requirement can only be a constraint on top of capital adequacy, so its addition can further restrict maneuverability and profitability.
• CAR ratios are lower in real life than in these examples. Most European banks run with ratios in the mid-teens, with banks in higher-risk countries or higher-risk lending niches having higher ratios. Mathematically, this means that banks either have more relative assets at the same risk-weighting or riskier assets. The average European bank would be more adversely affected under scenario three than our imaginary bank. 
• The impact of COVID was likely stronger than the NPL shock in scenario 3. It should have forced banks to provision aggressively. The regulators, however, permitted the banks to treat loans restructured under COVID-related programs as performing loans, not NPLs, eliminating most of the provisioning requirements. 

From these oversimplified scenarios, we understand that lower net interest margins drive vulnerability to NPL shocks. Such shocks may limit credit growth in the future. Moreover, if NIMs continue to tighten, it will be harder for any bank to work out any unforeseen problems.  Alternatively, banks working actively out of a crisis may have an opportunity to play catch up as RWA intensity and provisioning drops. 

Opportunities in European Bank Stocks: Long Side

With new knowledge in hand, I want to suggest two key themes that will drive my suggestions in this section and the next:

• A focus on banks whose risk weighting for assets can decrease from a higher base due to restructurings, sales, or market incentives.
• Banks in markets where demand for credit is likely to accelerate.

These points are critical in finding banks that stand to improve in the current environment. 

On the other hand, banks in countries closer to the end of an economic cycle are susceptible to a downturn in credit growth and an increase in NPLs. With interest rates as low as they are, banks in such economies could be especially vulnerable. We’ll cover an example in the next section.

For longs, I will focus on the Bank of Cyprus (LSE:  BOCH, OTC:  BACPY) and Eurobank in Greece (ATHEX: EUROB, OTC: EGFEY).  These bank stocks play on similar themes in the two countries, and both offer more compelling value than the broader financial space. 

Bank of Cyprus

Bank of Cyprus is the largest bank in Cyprus. As COVID area restrictions lift, BOCH stands to benefit from a further reduction in NPLs in its portfolio and increased economic activity in Cyprus. While other banks in Europe may offer a similar narrative, I believe this one is more credible and at a much lower valuation.

About Cyprus

It is an EU member and located on an island in the eastern Mediterranean. Cyprus has a GDP of ~US$25 billion, making it one of the smaller members of the EU. The country enjoys all the pros and cons of being a melting pot of eastern Mediterranean influences and also has been and remains a bulwark for UK influence in that region.

The main drivers of the economy are financial, professional, and tourism services. The country got into trouble during the Greek financial crisis of the last decade. Banks in Cyprus, including the Bank of Cyprus, owned large portfolios of Greek sovereign debt. Cypriot banks were also large relative to the country, and so when their portfolios of Greek bonds went bad, it became a real issue for the economy.

Thus, Cyprus became the first real test for the EU bail-in regime. Capital controls were imposed, and large deposits were converted into shares of the banks. The sovereign then raised funds to counteract the contraction caused by the banks’ collapse. The country also introduced the controversial citizenship by investment program to attract capital and an EU low headline corporate tax rate of 12.5% to bring in business, making its rate tied with Ireland’s.

With the zenith of the crisis more than five years behind it, Cyprus was in a pretty good position before COVID. The banking system had stabilized. Deflation and subdued inflation made it an attractive place for tourism and business, and it had kept a good chunk of its professional services business. 

Opportunity Now

COVID threw a wrench in things and clamped down on tourism and general economic activity.  With Cyprus reopening and its main tourism market (UK) in a good position, we can expect a gradual opening in the rest of the year to boost Cyprus activity. 

My key views for taking a position in Bank of Cyprus are the following:

• Valuations are not demanding, with the bank trading at a quarter of book value despite a significant run-up this year. 
• The bank continues to bring down NPLs. This helps in two ways: 1) it improves underlying profitability as new loans generate interest income that is not fully provisioned, and 2) it allows for increased credit growth (due to the lower risk weighting of newly originated loans vs. NPLs).
• The bank has excess liquidity of roughly EUR 4.2 billion on a EUR 21.5 billion balance sheet. This liquidity earns nothing and is a drag on returns. Deploying this profitability or reducing it via reducing deposits will improve profitability.

Longer-Term Tailwinds

There are also a couple of possible positive wildcards on the horizon. These are not to trade on, but a couple of points can change the game for an investment.

• Foreclosed assets: The bank carries EUR 1.5 billion in property assets on the book, which they claim are held 20% below market. The Cyprus real estate index has been rising steadily for a couple of years. This means that, at a minimum, this portion of the book should be unloaded at close to book value. 

Much like reducing NPL balances, this will allow the bank to profitability redeploy capital. Cyprus, like Portugal, should be able to cater to retirees or any Europeans looking for the low-cost, low-tax sun.

• EU Recovery Funds: Cyprus has been earmarked EUR 2.7 billion, or close to 15% of GDP, for projects. Such funds are more impactful in smaller, less developed countries and should provide an impetus for growth.
• Reunification of the Island: Cyprus is a split island, and while reunification or normalization of relations is unlikely over the short run, a change there could also be transformational.  A recent article from Strife blog provides a good summary, which you can read here.
• Natural Gas: There have been some pretty major natural gas discoveries in the eastern Mediterranean over the last couple of decades. While there have been a couple in Cyprus, they have not been of scale on their own to justify development.  If more discoveries are found within Cyprus or there is greater coordination with fields in other countries’ waters for development, it could be a game-changer. Don’t bank on it, but it is a free option now. Investment into infrastructure along with royalties for a small economy could be transformational. This also explains Turkey’s incursion in disputed waters to search for resources.  The politics are tricky, as this update article from S&P illustrates.  Eastern Mediterranean gas is at the nexus of the above reunification talks as well as broader EU energy security.

As with any idea, I should also highlight the negatives:

• Costs: It has been agonizing to watch this bank try and reduce costs. Ratios remain elevated, and the bank guides this to continue for the next couple of years. The bank has a lot of work to do convincing investors it can bring these down.
• Bank Size: Bank of Cyprus’ balance sheet is roughly the size of the Cypriot economy. This makes lending growth linked mainly to GDP. If the economy is not growing, it will be tough for the bank to extend its loans to improve profitability. 
• It’s Still Europe: The biggest savior for banks in Europe would be to allow interest rates to normalize in a non-volatile manner. I am not saying this is possible, but that would be a silver bullet for every European bank. Instead, European monetary policy continues to hollow out the sector. Should this continue or accelerate, it could cause issues for all banks.

Technicals

Lastly, there are the technicals for the Bank of Cyprus. As you can see below, the bank has been in a definite downward trend until the end of last year. Since then, however, it has rallied sharply like most financials but remains below its pre-COVID levels. It is comfortably trending above the 50 and 200 DMAs for the first time in over a year and just broke out of a six week consolidation zone and is starting to retracement.

This is a pick where I do not have a firm price target to the upside but am waiting for perception to move from terrible to just bad.  I have been long a small position since the high 60s and am looking to add on the current retracement.

Eurobank

Eurobank is one of the four leading banks in Greece, and I mentioned it briefly in my Greece-focused post. With the background covered in that post, we can skip straight to the opportunity.

Opportunity Now

Like BOCH above, Eurobank is a convergence trade. Since Eurobank has cleaned up its balance sheet, it has put itself in a position to increase credit and leverage and catch up to European peers. Here are some of the main highlights:

• The bank currently trades at 0.53x book, which is a premium for Greek banks but below European peers. A rerating from 0.5x to 0.6x implies a 20% return plus any growth in equity.
• I believe the Greek NPL cycle is different from Europe, even with the COVID shock. Thus, I think they could see a longer window of reduced provisioning than most European banks. The company is guiding EUR 900+ million in pretax income in the coming years, which means Eurobank would be trading at a mid-single digits P/E assuming minimal growth and just a normalization of asset quality.
• The re-inclusion and resizing of Eurobank in various indices. I talked about this a bit in my Greece post, but the banks suffered tremendously when MSCI and others kicked them out of the indices. More recently and going forward, they should stand to benefit from inclusions and reweightings.

Full disclosure, I have not completed my work on the other Greek banks to see if they could safely embody the same trade. I have focused initially on Eurobank because 1) it is the most advanced in reducing bad loans, and 2) it has had Fairfax as a major shareholder, which gives some testament to management. If you think the other Greek banks offer the same trade, then just buy a basket.

Even longer-term, I think the following points stack in Eurobank’s favor:

• Although still way behind, Greece has probably engaged in more constructive reforms than any other country in Europe. While it is still not even close to northern peers, the rate of change has been impressive. Balance sheets are being cleaned up, corporate tax rates are coming down, the lower cost of living and good weather is bringing in talent, and Greece is starting from a much lower base than the rest of the continent. This leads me to see that, like the NPL cycle, Greece should have a longer runway for growth.
• Greece has the same advantage with the EU recovery funds vis a vis Cyprus.

On the negative side, I think Eurobank faces the same systemic issues as the Bank of Cyprus above. The only other point is that you are paying a premium for Eurobank vs. other Greek banks, and perhaps that premium is unwarranted.  

Technicals

I dropped the ball and didn’t buy Eurobank after mentioning it earlier in the year. After consolidating for the start of the year, it broke through resistance around 0.58 and has been a pretty smooth ride up to where we are today. There should be some congestion and resistance between 0.80 and 0.90 cents where the shares traded pre-COVID.

It looks like there is a little support in the 67-69 cent range, so I may start a position in the low 70s.

Opportunities in European Bank Stocks: Short Side

I want to think about short ideas in bank stocks that are opposite to those named above. I have been following one bank that fits the bill here, a bank that trades at a premium to book and has ridden credit growth and interest rate conversion within Europe, perhaps past its sell-by date.

The bank is KBC Groep in Belgium (Brussels: KBC).  It has grown with above-average margins on the back of solid franchises in Eastern Europe, where margins and growth have been more robust for the past decade.

Margins have now converged in the Czech Republic, Slovakia, and Hungary to their main Belgium market. Furthermore, their provisioning for the last few years has been less than 50 bps per year. If you believe there is any chance of a slowdown in Europe, this bank is particularly vulnerable.

To highlight the main reasons:

• The bank trades at a price to book of 1.23x. In analyzing recent trends in profitability, that means you are buying at high single digits P/E but with a good chance that earnings will decline. This also says nothing about any shock to asset quality.
• Asset quality has recovered from the height of the European financial crisis and improved for nearly a decade. If there are cycles left, KBC’s core markets are likely due for one. Given how narrow their margins are, such a shock, as highlighted in scenario 3 in the first section, could wipe out a couple of years of profitability. 

This is not an attack on the management of KBC. They have navigated things admirably. Instead, this is a view on their limited options going forward and the high multiple the market is ascribing to their business.

What could go wrong with a short here?

• I am wrong about further convergence in interest rates and growth between Eastern Europe and the main part of Europe. If there is more room for interest rates in Eastern Europe to compress and credit continues to grow faster, this will invalidate my view.
• Every future unforeseen crisis in Europe will be managed like COVID, allowing banks to skirt the hard provisioning such events usually warrant.
• KBC is one of Brussels’ largest stocks, and although Belgium is a small, often overlooked market, KBC’s weighting and size make it a target for passive flows. Since the float is only about 60% of total shares, flows can be critical. If people continue to clamor for European value shares, a short will face those headwinds.

The nice thing about looking at something like KBC is that I think the market is already partially priced in the top two points. If they don’t materialize, I believe there is more room to go down than up. 

Technicals

KBC has rebounded from COVID but remains below its March 2020 levels. It has been consolidating between 57.50 and 62.50 for most of 2021. The stock had a break-out move in mid-March but has since retraced back to the rectangle’s top end. It could be coiling for another move higher.

This could happen in anticipation of or on the back of their 1Q21 earnings release in early May. YoY comps should be easy. If however it breaks back into the triangle it could be a good entry point.

A Note on Sizing and Timing

Here are a couple of quick thoughts on financials generally in a portfolio as well as timing. I hope they help you sort things; however, they are not substitutes for building your framework and process.

Sizing

Financials are highly leveraged institutions that, by nature, are not conducive to volatility but can make great investments after serious events. Even when the opportunity presents itself, I would rarely look to have bank stocks make up more than 10% of my portfolio and no single equity more than 2.5%. Currently, financials make up 2.3% of my portfolio, and Sberbank in Russia (discussed here and here) is the most significant portion. 

For shorts, I do not have a sound system in place. I have found with trial and error that I can build up to a 1% position, which is about the max I would have in any single name. I would also build this in increments subject to a maximum risk budget. It’s also important to say I do not expect this short idea to go to zero but rather to revert towards peer valuations.

Timing

My main concern is that we are heading into a global correction sometime in the second half of the year. I will save the details of that analysis for another time but suffice to say it will be difficult for financials. The long names I have mentioned can continue to do well in this type of period, but I want room for error to see how things play out. 

I will look at dips over the next few months as long as practical into the summer to trim into the fall. 

Conclusion

Banks are no longer just your parents’ savings and loan, nor do they just take your deposit and lend it to your neighbor to purchase a home. They are immense and complicated institutions with an ever-increasing number of rules impacting their flexibility and profitability.

I hope the illustration I provided at the beginning of this post clarifies some of the mechanics behind capital adequacy, profitability, and their respective drivers. With that knowledge, you can hopefully better understand past events and have a framework to understand future actions’ possible results. This applies to bank stocks in Europe and globally.

For investors willing to look at bank stocks, there are institutions in smaller markets with more straightforward business plans. These markets are long overdue to catch up to the rest of the world and should provide catalysts for more substantial earnings and investor re-ratings for their banks.  Conversely, I’ve suggested one name where the tailwinds seem more on the wane.  At a later date, I will cover other financials in emerging markets.  There are many opportunities further afield for investors looking for good houses in more volatile neighborhoods. 

To your investing adventure,

The Castaway Capitalist

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IMPORTANT DISCLOSURE: As of the date of publication, the Castaway Capitalist owns BOCH.

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