Holly Cook: For Morningstar, I'm Holly Cook. Is the outlook for the banks looking sunny at the moment? To help me answer this question today is Erin Davis. She is Senior Equity Analyst of Banks for Morningstar.
Erin, thanks very much for joining me.
Erin Davis: I'm happy to be here, Holly.
Cook: So the financial sectors had a really stormy couple of years, but is the horizon starting to look a little sunnier now or do we have some big clouds still hanging over us?
Davis: Unfortunately I think the outlook is still looking rather cloudy, both in Europe in general and for UK banks in particular. UK banks are facing small net interest margins now, because the banks are having to wean themselves off the special liquidity scheme and because there's not very much demand for loans. I think that that's likely to continue for some time.
Losses are also elevated and are likely to remain. So, both in the UK and – UK banks are highly exposed to Ireland and losses there haven't hit the bottom yet, I don't think. In Europe more broadly, I think there's some countries where recoveries are looking a little bit better, but it's still pretty slow.
Cook: So you mentioned Basel III there. What are the general implications for some of the key sector players?
Davis: Well, Basel III in general is aimed at both increasing the amount of capital that banks have to hold and also the quality. Before the crisis, a lot of banks held hybrid capital, which is debt that was supposed to convert to equity in the time of a crisis, but then during the crisis we found that that didn't actually happen.
So now banks are supposed to hold a lot more equity and what that means at the end of the day for investors is that returns are going to be lower.
Cook: So, are there any banks that might have to raise additional funds?
Davis: In general, when you see these scary headline numbers about banks in Europe, they have to get more funds – those are generally not publicly traded banks that are in the worst shape. It's mostly the German Landesbanks and the Spanish cajas and those types of things.
But there are a few banks that we're still pretty worried about. For example, Commerzbank in Germany is just wrapping up a rights issue but I think that if things don't go perfectly over there that they could still need more capital because their earnings power in general is so low.
We're also pretty worried about Dexia, which isn't in great shape and plus it holds a lot of Greek debt and if there is a 50% hair cut on that, as many investors think, then they could need more capital to fill up that hole.
Cook: Which then are you less worried about? Are there any that you are even positive about?
Davis: In the UK, some of our favourite banks are HSBC and Standard Chartered. Both of which we think are less exposed to the regulatory problems and to the UK economy in general. In Europe more broadly, we really like Credit Suisse. I think that is benefiting from the turmoil in Europe, both as investors move away from the Swiss franc and as they seek some safety and is also benefiting from the problems at UBS, its biggest rival, which is losing a lot of key employees.
Cook: So you mentioned the UK banks there, what's the prospect there for the government to reverse its part nationalisation of the RBS and Lloyds?
Davis: I think that the soonest that we'd see that is probably in September after the Independent Banking Commission report is published. But I think that it's probably going to be a little bit later. At a minimum the share prices have to rise above the government's buy-in prices which is about 50 for RBS and 74 for Lloyds, and both banks are trading substantially below that, especially Lloyds.
I think that sometime around 2012 it's likely to start and it may go on for a while with chunks being sold off here and there. I don't think investors need to worry too much about the market being flooded with shares. I think rather than selling them on the open market that government is likely to look for sovereign wealth funds or other private investors to buy large chunks of shares.
Cook: So, for investors in those specific UK banks, perhaps they don't need to worry so much about the government selling the shares, but the UK economy as a whole is weighing. Looking broader afield, it seems like it's fair to say there are definitely some opportunities out there but investors really need to be quite wary of the downside as well?
Davis: Yeah, I think that that's right. There's a lot of banks across Europe in general and in the UK that are trading pretty substantially below our fair values, but I wouldn't put a lot of money in any one specific name because there's a lot of individual downside risk to each name.
But in general, I think that there's a lot of banks that are going to get through this in a few years. They have enough capital right now. Losses will start to subside, and eventually things are going to look sunnier.
Cook: Thanks very much for joining me, Erin. It's good to hear that.
Davis: It was good to talk to you.
Cook: For Morningstar, I'm Holly Cook. Thanks for watching.
