This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here T. Rowe Price European Equity fund manager, Dean Tenerelli explains why investors should reconsider financial stocks from eurozone nations.
I believe the current financial crisis is bringing opportunities—similar to the early 1990s Nordic banking crisis—and could trigger industry consolidation in a number of markets, which eventually should prove beneficial for banks’ shareholders.
Over the last year certain southern European banking names have become considerably more interesting. Alongside attractive valuations and the scope for a recovery over the medium term, there is the potentially favourable impact of industry consolidation in some markets. Generally, the degree of concentration in a country’s banking sector has a major influence on banks’ profitability and balance sheet strength. In more concentrated markets, it is evident that the large players benefit from economies of scale and cost efficiency, as they are able to spread their fixed-cost bases over a greater number of products and customers. Also, in oligopolistic environments, we observe that management teams are more focused on returns and profitability, rather than continually chasing after market share.
In Europe, owing to the different structures of the individual national markets, profitability and efficiency have varied greatly among European banks. Ranked by average return on equity, we can see that Swedish banks have historically beaten banks from the five biggest European countries which, can be attributed to the highly concentrated nature of the Swedish market. In the aftermath of the financial crisis that swept the region in the early 1990s, the Scandinavian banking industry underwent a period of major restructuring and consolidation that ultimately worked to the advantage of the Nordic banks. The region went from an unstable competitive environment characterised by small, sub-scaled local banks to a new market situation where the five leading institutions in each Nordic country enjoy extremely high market shares and strong pricing power – allowing them to manage rates and costs effectively across market cycles.
This contrasts starkly with Germany where the operating environment for private commercial banks has historically been very challenging. The German market remains dominated by public-sector banks and small credit cooperatives, which do not necessarily consider profit maximisation to be their principal objective and often subsidise prices and rates to accommodate their customers. Therefore, and unsurprisingly, Germany’s banks have lagged their European peers historically both in terms of profitability and capital strength.
I believe the current financial crisis is bringing opportunities—similar to the early 1990s Nordic banking crisis—and could trigger industry consolidation in a number of markets, which eventually should prove beneficial for banks’ shareholders. I am heartened particularly by the changes taking place in Spain. In the “boom years” that led up to the crisis, the Spanish banking industry was littered with a number of small local savings banks (cajas) with over-expanded capacity that had built large exposures to the real estate market. As the crisis unfolded, the Spanish banking sector was victim to the dislocation of wholesale credit markets together with the burst of the real estate bubble. The sharp economic downturn that ensued triggered a rapid de-leveraging and risk re-pricing by Spanish banks. Credit growth collapsed, loan-loss provisions soared and capital safety buffers were rapidly eroded.
Faced with the cajas’ limited ability to raise equity and the prospects of increasingly demanding Basel III requirements, the Spanish government was forced to take drastic measures, prompting a stunning consolidation of the banking industry and a rapid reduction in its excessive capacity. Through liquidations, mergers and takeovers, the number of institutions declined from about 50 to 12 while the numbers of branches and employees was cut by 20% and 15% respectively. Our holding in Bankia (BKIA), for example, was formed from a seven-way merger of small local savings banks, and today is the third largest bank in the country by deposits. The most troubled assets from the founding cajas were transferred to the government-backed “bad bank” (SAREB), leaving Bankia essentially with a solid and profitable retail business with the potential, in my opinion, to eventually generate double-digit returns as the macroeconomic situation in Spain normalises and the company benefits from a gradual recovery in volumes and net interest margins.
With industry restructuring in motion in Spain, its banking sector is now consisting of bigger and better-capitalised institutions benefiting from structurally higher pricing power and set to operate in a more rational competitive environment. I believe this should translate overtime in improvements to underlying profitability, which should cause valuations to adjust accordingly. In anticipation to these changes, I have built a sizeable position in Bankinter (BKT), a high-quality Spain-based retail bank. At present, the market fails to appreciate the quality of the bank’s business and the ongoing improvements in its return profile. While lower provision charges and improving funding conditions are supportive of Bankinter’s interest margins in the near-term, I expect margin expansion to be driven by enhanced pricing power and favourable changes to the bank's asset mix as it rebalances its loan book towards higher yielding assets, such as SME/corporate lending. Bankinter is one of my high-conviction names, which I believe has the potential to take market share and sustainably grow in this higher-margin segment. Thanks to its strong capital position and superior asset quality, it does not require significant de-risking or reductions to the size of its balance sheet. The management team’s focus and strong record in generating shareholder value is an added advantage reinforcing my high conviction in the business model and prospects of the company.
Morningstar Disclaimer
The views contained herein are those of the author(s) and not necessarily those of Morningstar.
