Welcome to Know More, Risk Better, a Credit Sites podcast. Across the global strategy team, we aim to make sense of the macro and the micro, highlighting opportunities and the risks facing the fixed income markets. As the macro makes headlines, we leverage our network of experts across fixed solutions to better understand economic trends, rates, gyrations, geopolitical events, and how these factors impact corporates. At Credit Sites, we understand that credit investing comes down to picking winners to generate alpha and avoiding losers.
Our team of over 100 analysts across the U.S., Europe, and Asia provide unmatched expertise and fundamental knowledge. In our weekly podcast, the strategy team offers a look at the conversations we have with our colleagues, including analysts, fellow strategists, economists, and leveraged finance market experts. If you want to know more so that you can risk better, you'll want to give this podcast a listen. Hi, everyone, and welcome back to the Credit Sites podcast.
My name is Logan Miller, and I am the head of European strategy here at Credit Sites. And today, I am joined by my colleagues, Simon Adamson, who is the head of financials here in Europe, as well as Paolo Bereski, who is the head of Southern European banks. And we're going to do a full 360 view of what's going on across European banks. So, welcome, everyone.
I'm Simon and Paolo. I'm glad to have you here. Good to be here. Thank you, Logan.
Good to be here, too. All right. So, let's start off with what's probably most topical right now, just given we had a full year 2024 earnings results just over the last few weeks or so. So, I guess let's start with Simon.
And I guess, you know, what themes have emerged so far across the current season and how you see 2025 playing out so far? Yes, you are. And everyone who follows European banks will know that the earnings season has spread over quite a long period. I reckon we've had about three-quarters of the earnings so far.
So, we do have a pretty good idea now what the main trends are that we're seeing. I guess the main takeaway is that really there'll be very few surprises. You know, earnings have been pretty much in line with or a little better than expectations, and hence you have either a neutral or a mildly positive reaction in both the equity market and the bond market to those earnings announcements. The capital ratios look stable, despite the fact that the banks are upping their dividend payout and implementing more share by banks.
And asset quality earnings are pretty strong on the whole. So, I think what I'll do is I'll take each of those in order and have a little bit of a look in more detail on those different elements. I guess let's start with asset quality. Space-free loans, which are impair loans or non-forming loans, have been generally stable.
Now, that is slightly surprising. We thought at the beginning of the year we might see a little bit of a rise in space-free loans given the fact that we've had higher interest rates, that we've had weaknesses in some sectors such as commercial real estate. But actually, the ratios remain low in the historical level and, as I say, have been pretty stable. We've seen one of two cases where the space-free ratios have come up a bit, but that's for specific reasons.
So, for example, Deutsche Bank with its US commercial real estate exposure and HSBC with its Hocombe commercial real estate exposure. If we look at two loans, which is where we've seen a significant increase in greater risk, although the loans are generally still performing, we've seen those actually fall quite a lot in many cases. I think that's a bit of a mechanical thing. It's dependent on probability of default, and that, in turn, is really dependent on banks' outlook for the economy.
And in general, banks have become a little bit more positive about the economic outlook. So, that's the reason we've seen that. And then, if we look at the income statement, loan and payment charges have been, I think, either sort of stable-ish or trending up slightly, but they're certainly still, in most cases, below what most banks would fall there through the cycle level. So, there's no real sign of any particular threat at the moment.
As I said earlier, we did think that commercial real estate might be an area of weakness, but, actually, risk seems to have remained pretty low, certainly in Europe. We have seen some higher losses in the US, but most European banks are not really exposed to the US commercial real estate market. We've seen some weakness in Hong Kong, but that's not really translated to higher loans because cultural levels are very good there. And then, the other area we thought might be a little bit weaker was consumer finance, again, because of the higher rates.
But we haven't really seen that in Europe or the US. Standard Chartered did see a bit of an uptick, presumably in Asia. But, apart from that, it's all been fairly stable, really. And then, if we move on to capital, again, it's been a fairly stable picture, despite, as I said, banks increasing dividend payouts and doing more share buybacks.
And most banks seem to be managing down their capital ratios a little bit over the medium term. Which is looking for so-called excess capital to be returned to shareholders. And then, on the other hand, the bond market and the regulators, which tend to like to see higher capital ratios. Having said that, I think target levels for banks' capital ratios, their common equity tier one ratio, should still leave so-called MD equitums, which is basically the buffer over the minimum capital requirements, at quite strong levels.
It's not something we see as a particular concern at the moment. And then, finally, just on earnings, profitability, whether it's return on equity or return on tangible equity, still looks pretty good in a historic context. We do think there might be a little bit of a drop-off in 2025, mainly because of lower interest rates. And, in general, higher rates are better for net interest income and net interest margins.
It does vary a little bit the effects from country to country in fact the bank, but, in general, higher rates are positive in that respect. And, as rates have started to come down, we have seen probably the majority of banks, not all banks, the majority of banks, starting to see their net interest margins squeeze a little bit. But the fact that rates are being higher for longer than expected is actually a bit of positive for most of the banks. Of course, net interest income is a big part of banks' operating income, so it's an important metric to follow.
And banks have been deploying structural hedges quite a lot to protect net interest income. And also, it's been offset by generally good fee income by most banks, and a lot of banks have to do with good activity in their wealth management operations. So, overall, just to summarize, it's been a pretty strong 2024. For most of the banks that we look at, we do think there will be a mild drop-off in 2024 because of those rates moving lower, but we still do see a pretty positive outlook for fundamentals going forward.
That's really helpful, Simon. Thanks so much for that. It sounds like stability is sort of the name of the game for now, which I guess is feeding into some pretty sanguine views on credit risk overall. And we've seen performance across the banks do quite well, so we'll get into that later on this podcast.
But let's jump down to Paula Peller. Some of those themes that Simon mentioned, are those really kind of similar across the sort of European banks, or are there any sort of differences that you point out here? I would say they are indeed broadly similar. I mean, Portuguese banks haven't actually disclosed the fourth quarter earnings yet, but in terms of our expectations, we anticipate to see some sequential decline on the top line, driven by, as Simon mentioned, the lower asset margin and only partially mitigated by lower funding costs.
But profitability and capital generation should remain comfortable, particularly due to the lack of a major downturn in the credit cycle. And in fact, we anticipate these themes to be recurrent this year. On the other hand, Italian and Spanish banks have disclosed the full year figures, and they show quite healthy operating trends. For example, Santander was able to upgrade its capital target in terms of CTE1 ratio to 13%.
And in this way, they actually addressed what we saw as one of the key weaknesses of the investment case. And this should be flattering to the CTE1 valuation, where we do have a cheap, so buy a recommendation. Sabadell saw material improvement in asset quality, very strong volume growth, and lower cost of funding. BBVA also had a very healthy fourth quarter, despite the market concerns on Turkey and Mexico, to which they're exposed.
And they even indicated that profits this year will be at least aligned with last year. If we move across to Italy, the picture was a bit more mixed here. The negative sensitivity to lower rates is perhaps more evident. And so there was a sequential decline in the top line.
But still, this didn't prevent some banks, for example, Intesa or Banco BPM, from upgrading the forward-looking financial guidance. And remaining in Italy, you need credit to some erosion in its capital level, which we think is set to continue, very much due to the M&A strategy. And this is a credit that we don't like in the general part of the capital stock, so we have a rich recommendation on ETI1. All right, so let's move on to another theme that's been a big focus, I guess, for the last kind of 12 months or so, which is M&A across the European banking landscape.
So, for instance, we've had Unicredit interested in Commerce Bank, Monty De Pesce keen on Mediomanka, and we've seen a handful of deals kind of unfold. So I guess, Paola, first of all, which deals have you been looking at, and generally, how do you assess the credit impacts stemming from a potential deal across some of these ones that have been announced? So we have had indeed a concentration of various deals in the European banking sector. In fact, there are six or seven that we've been looking at.
Firstly, Unicredit put forward an exchange of 400% of Banco BPM in a 13 billion euros deal. BBVA is also an acquirer of Sabadell in a 14 billion euros deal. Banco BPM made a cash offer of 100% to Banima. It recently sweetened the terms of the deal.
It is now worth 2 billion. And Banco BPM also invested some 800 million euros for a 9% stake in Monty De Pesce. Unicredit, back to Unicredit, they also invested 6.5 billion euros to build an economic interest in Commerce Bank, with a view to potentially take over the bank under certain conditions, and not before early next year. They also committed 2 billion to be the stake in Generali.
And Monty De Pesce, as you mentioned, launched a surprising exchange offer for Mediomanka. Here, Monty is actually more low-rated and smaller market value-wise than Mediomanka. The offer was worth 13 billion euros when Monty launched it at the end of January. But given changes in the relative market cap, it is now worth slightly over 12 billion euros, which is actually 10% below Mediomanka's market cap.
So here, clearly, the market does not think that the deal will go through. And finally, we've had Bipper Banca, in our universe, committing itself to buy a Banca Popularity Sondro, also in a shared exchange deal that values Sondro at some 4 billion euros. How do we assess the impact stemming from these deals? It's quite difficult to have a one-size-fits-all approach.
First of all, let me say that most of these deals were not agreed with the target. Many of them, for example, BBVA Sabadell, Unicredit Commerce Bank, Unicredit Banco BPM, were actually labelled as hostile. And this is quite a deviation from the past. In fact, historically, banking deals were mostly friendly and therefore featured less execution risk.
Now, even in hostile, we think that some of the deals we listed have good chances to go through, for example, BBVA with Sabadell, but getting the required regulatory approval will take longer, and also the terms may have to be renegotiated, something that, for example, anticipates could happen in the Banco BPM Unicredit deal. And when predicting the M&A impact on the credit spread, we look at various aspects, for example, the capital position of the combined institution post-deal, the likelihood of the deal going through, the profitability outlook, which crucially depends on the extraction of synergies, and any relevant change in the competitive position. Depending on those aspects, one can then assess whether there can be a spread convergence between the target and the buyer, or a widening or a tightening in both. And generally, I would say that the analysis is perhaps most straightforward when a stronger and larger bank takes over a weakened institution.
And it's relatively easy here to predict that the credit spreads of the target will realign toward those of the buyer. For example, that happened with Sabadell and BBVA. It happened when Bankia was taken over by Kasia, or when UbiBankia was taken over by Intesa. And in all these instances, we had a created recommendation on the target.
But on the other hand, some of the banking deals that are currently pending are not motivated by the weakness of the target, but whether by scale, diversification, or by political or defensive rationale. And this is very much the case, for example, in the Monte-MedioBanca deal. And here, the target, MedioBanca is actually the stronger credit. So if you think that the deal will go through, you should sell it.
But we are not positioned that way. We are recommended to be neutral on MedioBanca, and we remain positive on Monte, because we actually see both banks as potential targets, and we don't think that the deal has good chances to go through in its current format. All right. So really kind of sticking with the M&A thing here, Paola.
So who, I guess, do you see as sort of natural buyers or targets? And what's next for European bank consolidation and your deals? So the natural buyers are the larger institutions. So, for example, BBVA in Sampdell in Spain or Unicredit in Italy.
But even for those, one has processed potential antitrust issues that could prevent the deals, and also the specific CEO's strategic willingness to pursue a deal. For example, Intesa, which is the largest Italian bank, is unwilling to expand further at this stage. The natural targets are the smaller institutions that lack economies of scale. For example, NovoBanco in Portugal, Monte de Pasqui, or Banco BPM in Italy, Sampadel in Spain.
Novo is a name that is not going to be involved in M&A, but we are positive on the tier two, not just because of the positive capital generation, but we think they will also get involved in M&A as a target. Now, cross-border transactions are far less frequent. With Unicredit, it should be, and now potentially, a commerce bank being an exception rather than the norm. We think there is too much lack of political, economic, and fiscal union in Europe, and also a very fragmented legislative environment that make the cross-border deals an exception rather than a rule.
And it's also worth mentioning that, in addition to these domestic deals incentivized by the extraction of greater economies of scale, we are also likely to see more deals across verticals of financial services, incentivized by the acquisition of a non-bank revenue stream at an advantageous capital condition. Most recently, for example, Unicredit and Banco BPM opted to fully internalize their life insurance business. Banco BPM launched a bid on 100% of Anima. BMP, which is AXA Investment Management, and Generali struck a deal with Natixi, in the asset management business, to create a JV with close to 2 trillion euros of asset management management.
So we may see more of these kind of transactions as well. All right, that's very useful. So we talked on earnings results, M&A, so let's move on to every banking analyst favorite topic, which is regulation. So I guess let's turn to Simon now.
So Simon, where do you think stand right now with the regulatory environment for banks? Well, I guess we've seen a huge amount of regulatory change over the past 10-15 years following the global financial crisis, and that has really resaked profitability, and it's changed the environment for investors as well. But we're pretty much at the end of that process now, so there's a lot less change coming out of the pipeline. So I think it's possibly something that we're going to be talking a bit less about than we have in the past.
There are two things that we've been going to eye on for this year. One is Basel 3.1, or Basel 4, which is basically the final Basel capital package. However, the implementation, certainly at a global level, has fallen away a little bit, I think. It's certainly not being very well-coordinated at the moment.
So the package is introduced in Switzerland this year, and in the EU, except for the part that concerns the trading book. But because there's a big question mark over how it's going to be implemented in the US, particularly with the change in government there, the UK has delayed implementation until 2027. So overall, though, I think it's been a little bit of a non-event. It's been well-flagged, it's been delayed several times.
Banks have been able to take some mitigating actions. A lot of the elements of it have been diluted a little bit as well. So as far as we can tell, the impact on those banks has actually been pretty small. So it's much less of a change than we thought it would be three or four years ago.
The other thing that we're looking at is the social CMI crisis management and deposit insurance package. It hasn't been finalised yet, it hasn't been totally agreed. So I think it's probably going to be, if anything, 2026 rather than this year. But the main element of interest, I think, for the bondholders there, will be the introduction of deposit preference.
There's only a few countries that have that in the EU at the moment. It's going to have a couple of things. I think, first of all, we're going to see... One fact goes through, quite a lot of downgrades by Moody's of preferred senior ratings.
That's mainly because they use a given default model, unlike the other two main rating agencies. So we don't think you'll see rating changes at the end of it, but you will certainly see some at Moody's. But I don't think that's going to have that much effect on spreads, to be honest. The long-distance effect is potentially a bit more interesting.
We're waiting to see how this might affect the way the banks look at their issuance, particularly non-preferred versus preferred senior. It could be the banks decide they don't need as much non-preferred senior going forward because preferred senior fulfills that sort of bail-in role now that we'll have deposit of preference. So certainly there could be some big changes going forward. But I think those are the two main regulatory changes that we're looking at just at the moment.
All right, so I guess with regulations always comes capital buffers and issuance. So on that topic, issuance seems to be, I guess, fairly robust, particularly on a growth basis. But are we seeing anything that's interesting going on on the primary market side? Or do you see anything, Simon, that you think might change in the near term?
Well, I think what we're going to see is how that balance between preferred and non-preferred senior plays out. I think that's a little bit more medium term. I don't think that's really going to be a feature this year. As far as issuance is concerned, yet we've got a strong start of the year, as we do in most years.
I think deals seem to have come pretty successfully. We've seen big order books, which suggest the demand is pretty high. The bank paper and pricing has tightened in pretty well from initial price-ball levels. I think overall, we're expecting a little bit higher issuance this year.
We saw, on the banks that we track across senior subordinated, 81, we saw about 310 billion euros equivalent last year. Expectation for this year is around 335 billion, but some elements of that are a little bit more difficult to predict. But what we're saying is that we're expecting this to be primarily refinancing business, you know, refinancing upcoming maturities and calls. We don't see a lot of new issuance.
We don't see a lot of value-tree growth coming up. So I think that it's going to be quite similar to last year overall. We get asked by a lot of 81, which is obviously a big focus for a lot of investors. Again, I think that's going to be mainly a refinancing market.
And we've seen that in the first couple of months of this year, you know, banks basically refinancing or pre-financing upcoming calls. And we do expect, generally, banks to call their 81s as they did last year. And so we're expecting to see somewhere around 35 to 40 billion euros equivalent of 81 issuance again this year. Yeah, it seems to be a theme, you know, even across the non-financial segment of the European markets of most new issuance focused on refi.
At the same time, we have still very strong demand for corporate bonds, and that's keeping, you know, secondary credit spreads quite tight. So let's move on now to relative value and positioning across the banks. So, you know, banks have had a very good run in the last 12 months in terms of credit spreads. And so if you look at, you know, where things are trading now, banks are actually now within just a few basis points of non-financials at sort of the sector level.
So, Simon, how is the banks team thinking about positioning across European banks? And we'll first start in terms of, you know, capital structure allocations. Yeah, well, we've come to the year with pretty tight spread, of course, you know, because we had a strong problem last year in the banking sector. Based on our expectation that fundamentals would remain positive, we therefore thought this would be quite a stable year.
We didn't see a lot of upside for spreads. And in fact, what's happened in the first couple of months of this year has slight surprises in the way that the spread has gone tighter. You know, in most respects, banks have probably outperformed the wider market a little bit this year. I think part of that is the fact that their full-year results have been good.
Part of it is that, you know, the economic outlook has remained relatively stable despite some of those geopolitical tensions that obviously people are looking at at the moment. So we've been fairly happy we have a market perform recommendation on preferred and non-preferred senior as well as on tier 2. You know, we think spreads are slightly to look a little bit tight there, but we don't really see a catalyst for, I think. So, you know, while we don't see that much upside from this point, we are happy to how the market performance will retain that for now.
We have had an outperformed recommendation on 81 for some time. And that so far, obviously, has been justified this year. The excess returns have been strong. We've seen some quite pretty good thread tightening on 81s.
So, you know, obviously, if we continue to see thread tightening there, the conversation we're going to be having is whether we should move 81s back to market perform. But to be honest, we still see yields as being pretty attractive in that market. So, you know, I think given that we do have those geopolitical tensions around, particularly uncertainty over things like Paris and how that will affect wider economies, as well as obviously the conflicts in the Middle East, in Russia, in Ukraine, whatever, then, you know, I think that there is some possibility there that we'll see some weakness and some widening there. So I think we would generally focus on some of the stronger names, some of the greater names in the 81 markets.
I think you're still getting good returns with yields on those banks. Obviously, there are some specific stories, as Carla was talking about, you know, in M&A, in Italy and elsewhere, where that could drive rates from our main recommendations as well. So overall, yeah, market perform on senior and softs, outperform on 81s, and I think we're pretty happy with those recommendations at the moment. All right, that's good to know.
So I guess kind of final topic here. Are there any, you know, country-level or regional-level themes that we can draw on or any takeaways in terms of our preferences there? Not necessarily at the moment, I wouldn't say. I mean, I think certainly in the past, you know, people would have talked about open ones, say, general banks versus Italian banks versus UK banks.
But I think if you look at fundamentals across the European banking sector at the moment, a lot of those gaps have narrowed. So whereas a few years ago, you've got some countries where they have significantly worse quality than others, I think in countries like Italy or Ireland, for example. That is no longer really the case. And it's the same with profitability as well.
So I think those country or regional differentials have closed up a lot. So I think we're tend to look more face-by-face on the bank basis rather than sort of regional country basis at the moment. So, for example, within UK or within Italy, there will be some banks that we want for some various different reasons. And I'll see some recommendations very much based on that rather than sort of seeing any particular banking sectors as being stronger within another just at the moment.
All right, that's very helpful. So, yeah, I guess we can wrap things up there. Obviously, for those who are listening, if you have follow-up questions for either Simon, Paola, or myself, please, I would recommend using the Ask the Analyst function on the CreditSites.com website. Thank you all for your time, and I look forward to doing another update sometime soon.
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