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Europe banks may not be a risk…but are they a buy?

In an effort to soothe frazzled investor nerves and temper some of the volatility seen in financial markets this year, banking analysts have issued an almost uniform response on the embattled sector.

Fears are overdone, they believe, stating that liquidity and capital buffers in European lenders have strengthened considerably since the global financial crisis of 2008. They also highlight that emergency funding for banks from the European Central Bank (ECB) remains relatively untouched.

The European Central Bank President Mario Draghi addresses a news conference at the ECB headquarters in Frankfurt, Germany, January 21, 2016.
Kai Pfaffenbach | Reuters
The European Central Bank President Mario Draghi addresses a news conference at the ECB headquarters in Frankfurt, Germany, January 21, 2016.

But, just because brokers on both sides of the Atlantic are seemingly not too concerned about another full-blown recession, doesn't mean they are recommending you buy these banks either.

The specter of negative interest rates and a lack of any earnings or dividend growth mean that even though European banks are now looking relatively cheap, the long-term outlook for gains is still not great.

"We don't see a liquidity crisis in European Banks (including Deutsche Bank) and we believe that the banks will be able to fund in private markets, well below current spreads if necessary, as we witnessed during the sub-prime/ euro zone crisis. So do we buy European banks now? No, as we remain cautious, with management and analysts being behind the curve in our view on earnings and dividends," said banking analyst at JP Morgan, Kian Abouhossein.

Much of the volatility seen in markets this month has been attributed to fears that European banks might struggle to meet their liabilities, with the spotlight on German lender Deutsche Bank and its ability to make coupon payments on its CoCo or additional tier 1 bonds.

Contingent convertible—or "CoCo" bonds differ from regular convertible debt in that they only convert to equity once a specified event has occurred, such as a share price hitting a certain level.

U.S. banks are more attractive than their European counterparts, as without the risks of CoCo bonds, which are still not very popular in the U.S., their capital structure is better, Abouhossein added.

"I think the threat of negative interest rates has really spooked markets, but I think the risk of a sustained low oil price is something else that carries significant uncertainties. I think there could be knock-on effects that we have not seen yet, stemming from a range of economies," Simon Willis, head of research and banking analyst at Daniel Stewart, said.

"It may be that the (capital) buffer is adequate, but I think at the moment markets fear, and investors feel they just don't know," he added.

Negative rates will likely erode bank profits by 5-10 percent according to Head of European Banking Research at Morgan Stanley, Huw Van Steenis, who said that a deposit rate cut beyond 10-20 basis points, could have an "exponential" impact on earnings.

"With rates set to remain lower for longer, margin pressure is set to be one of the biggest concerns for European banks also in 2016. We are concerned another bout of ECB QE (quantitative easing) will be negative, not positive for the banks. Moreover negative rates really concern us," he said.

Morgan Stanley believe banks with a stronger asset and wealth management bias look set to benefit from ECB policy, such as UBS and Credit Suisse.

JP Morgan's pick of the sector also included Danske Banke, along with Lloyds, which was bailed out by U.K. taxpayers in 2008 and Austrian bank Erste Bank.

"We want to own dividend-paying, high cashflow-generating banks which can sustain shocks … these banks are not the highest dividend yield payers but we have high conviction on dividend per share (DPS) to be delivered," Abouhossein said.