European Banks in 1Q24 – are they what we expected?

The European banks within our SGD credits universe have reported their 1Q24 results and we are mostly (pleasantly) surprised. In general, the banks’ performance has stood more resilient than initially expected, especially with macroeconomic conditions still uncertain.

Looking ahead, welcoming the dawn of ECB rate cuts, we outlined our view on the financial performance and credit profile for major European bank issuers.

1. Expect net interest margin to compress and net interest income to normalise

Looking at 1Q24 results, NIM and NII remained resilient across most European banks (Table 1 & Chart 2), albeit with some slight fluctuations. This helped with their performance in 1Q24, with the majority seeing another profitable quarter. We believe the resilient NIM and NII are likely due to:

1. Structural hedge allowed interest income to be maintained to a certain extent. We understand that several banks have increased their position of structural hedge last year, owing the strong market expectations of pending rate cuts. The hedged position for these banks has worked relatively well for them, being able to mitigate the pressure of higher deposits passthrough.
   
   
   For HSBC, it highlighted that the increased structural interest rate hedging helped with reducing its Banking NII sensitivity – for a decrease of 100 bps in interest rates, the sensitivity reduced from USD -7.0b as of 30 June 2022 to USD -3.4b as of 31 December 2023. Since then, HSBC further increased its structural hedge position from USD 478b (4Q23) to USD 487b (1Q24).
   
   
2. Prospects of higher-for-longer interest rates have helped to keep loan rates elevated. We saw strong market expectations of rate cuts at the start of the 2024. However, economic data in the US has shown to be more resilient than initially expected, resulting in the adjustment of rate cut expectations to merely one or two by early next year (Chart 3). As interest rates are expected to remain higher for longer, banks benefit greatly from the higher rates it can continue to price on loans.

We expect the banks’ net interest margin (“NIM”) to begin falling in 1Q24, given the decision to leave policy rates unchanged across major central banks. Both the Federal Reserve and Bank of England left policy rates unchanged since August 2023, while the European Central Bank (“ECB”) started its rate pause slightly later in September (Chart 1).

As rates stay unchanged and banks compete for retail funding, there is increasing pressure to offer competitive (higher) deposit rates. This results in an increase in deposit beta (percentage of changes in interest rates passed on to consumers) which caused NIM to compress as higher deposit rates represent higher interest expense for the banks.

On the other hand, we observed a slight shift to focus more on non-interest income, as proportion of net interest income (“NII”) to net income has fallen year-on-year in 1Q24 for a majority of the banks. Favourable market conditions and trading activities have likely contributed to improved non-interest income in the first quarter. We expect banks to increasingly focus on growing their non-interest income to mitigate the reduction in NII.

Chart 1
Major central banks policy rates since 2021 (%)

Table 1
Net Interest Margins for European Banks and respective changes QoQ and YoY

Chart 2
Net Interest Income across the year and proportion against net revenue (in USD m)

Chart 3
Implied Federal Funds Rate (%)

2. Capital ratios remain well-buffered against regulatory requirement

Most banks experienced a highly profitable FY23 and this should allow the banks to accrue capital and improve their capital positions. However, most banks experienced a decline in CET1 ratio year-on-year in 1Q24 and consequently, a decrease in the buffer to regulatory requirements.

We believe this due to the increase in risk-weighted assets (“RWA”) which offset the increase in capital. Elevated interest rates have increased the underlying credit risk of the banks’ loan portfolio, consequently increasing the amount of RWA.

Despite the drop in CET1 ratio and buffer, most banks remain relatively well-buffered against their respective regulatory requirements for capital. With that said, we noticed an increase in CET1 regulatory requirement across the board in 1Q24. We believe the higher requirement might have been imposed after the annual regulatory stress test, likely including additional requirements post-banking crisis in March 2023. We expect the banks to be more prudent with the use of their capital in view of a potentially weaker NII in general.

Chart 4
CET1 buffer against regulatory requirement (bps) and YoY change in CET1 for 1Q24

3. Prospects of soft landing will limit non-performing loans

The global economy remains resilient and the likelihood of a soft landing has risen. Considering this backdrop, we anticipate non-performing loans ratio (“NPL”) to stay rangebound this year, with banks seeing minimal increment in total loans portfolio given high interest rates. Thus far, our view has largely come true (Chart 5).

We see a divergence in the state of loans across geographies. A large degree of loans in UK and Europe remained relatively stable since FY23, while loans in the US saw increasing loan loss provisions and higher NPLs. Some of the banks have began addressing their US loans exposure in their recent earnings release, particularly in US Commercial Real Estate sector in light of significant drops in commercial property valuations. While others, like Barclays, saw a higher loan loss rate coming from its US Consumer Bank business (primarily offering credit cards).

As we expect economic conditions to stay largely resilient, we continue to hold the expectations for muted non-performing loans. The focus will be on banks with significant overseas exposure – i.e. Barclays with its US credit cards business and HSBC with Hong Kong and China real estate loans.

Chart 4
NPL loans ratios have largely fallen across the past quarters. Deutsche & Lloyds have seen greater fluctuations.

We like bank bonds …but some are more attractive than the others

With banks staying profitable, we continue to hold a positive opinion on the bank bonds. Below we highlight a couple of the bank bonds that we like and also included a summarized credit update on their recent performance.

The Commerzbank’s Tier 2 subordinated bond offers attractive yield at its bond credit rating of Baa3 by Moody’s and BB+ by S&P – and might see a rating upgrade from S&P given the positive outlook placed by the rating agency. Meanwhile, BPCE’s Tier 2 paper offers great value for an investment-grade subordinated paper, while Deutsche’s senior non-preferred will be ideal for investors looking for slightly lower risk to loss absorption.

Table 2
Recommended SGD bank bonds

Groupe BPCE

For the quarter ended 31 March 2024 (“1Q24”), BPCE experienced a -1% drop YoY in net banking income from EUR 5,815m (1Q23) to EUR 5,753m (1Q24). On the other hand, net income rose by +64% YoY from EUR 533m (1Q23) to EUR 875m (1Q24), primarily due to the absence of Single Resolution Fund (“SRF”) contributions in 1Q24. Previously in 1Q23, the contribution to the SRF accounted for EUR 585m of the EUR 4,587m operating expenses. Excluding the one-off SRF contributions, operating expenses increased by 4% YoY from EUR 4,002m (1Q23) to EUR 4,151m (1Q24).

The fall in net banking income was due to weakened performance across its two major banking networks - Banque Populaire (“BP”) and Caisse d’Epargne (“CE”). The two major banking networks make up the majority of BPCE’s 1Q24 net banking income at approximately 51%. Both networks experienced a drop in net interest income, with BP seeing a -11% YoY drop while CE seeing a -20% YoY drop – resulting in a decline of EUR -163m in net banking income for 1Q24.

Meanwhile, all other segments recorded slight growth across the year, offsetting some of the impact brought about from the BP & CE networks. The Group’s ‘Asset & Wealth Management’ business and ‘Corporate & Investment Banking’ business contributed the majority of net banking income growth at EUR +26m and EUR +49m YoY respectively. An improvement in commercial activity contributed to the growth in these two business segments, given optimal market conditions promoting trading activities and fund inflows.

BPCE’s asset quality generally stood stable across the quarter, with NPL ratio constant at 2.4%. The total provisions saw minimal increment from previous years’ figures – from EUR 14.2b as of December 2022, to EUR 14.3b as of December 2023, to EUR 14.4b as of March 2024. While Stage 3 loan provisions have increased across the past few years, we noted that the figure remains well below the provisions made before the pandemic period. Other than a slight concentration in France, BPCE’s loan portfolio is sufficiently diversified across counterparties – with the majority being individual customers at 30% (of which, 25% are residential mortgages) and corporate customers at 29%.

Lastly, the capital and liquidity position for BPCE continues to stand robust. The CET1 ratio is at 15.6% as of 31 March 2024, with a substantial buffer of 515 bps to the regulatory requirements. The average monthly liquidity coverage ratio was at 152% as of 1Q24, above the regulatory requirements of 100%. BPCE indicates a total liquidity reserves of EUR 324m, which covers for approximately 35% of the total deposits within the major banking networks.

Commerzbank AG

For the quarter ended 31 March 2024 (“1Q24”), Commerzbank saw its quarterly profit rise to record figures. Its net result rose to EUR 747m in 1Q24, representing +29% YoY and +89% QoQ increments. The strong performance in 1Q24 had been a result of higher net commission income against the previous quarter, while net interest income remained stable across the same period. This is further helped by lower costs in 1Q24, with cost discipline reducing overall expenses by -8% YoY and -2% QoQ.

In the 1Q24 results announcement, Commerzbank revised its expectations for FY24 NII – now expecting NII of EUR 8.1b for FY24, slightly higher than the previous projection of EUR 7.9b. The figure continues to indicate a fall-off from FY23’s NII at EUR 8.4b, largely due to the bank’s expectation of average deposit beta in Germany to increase for FY24. The bank also expects the average ECB deposit rate to be at 3.8% for 2024, down from the current level of 4%.

mBank, its Poland banking subsidiary, remains as the key concern for Commerzbank’s operations, owing to the ongoing legal risks regarding the Swiss Franc loans. However, its cumulative provisions catered to the legal risks is now at EUR 1.9b, more than sufficient to cover for the total volume of Swiss Franc loans at EUR 1.6b and reflecting a coverage ratio of 116%. We are also encouraged by mBank operational results, which saw a record quarterly profit in 1Q24 as well when excluding the provisions made for the legal risks.

Asset quality improved as compared to the previous quarter, with the cost of risk on loans falling from 23 bps (4Q23) to 11 bps (1Q24). Commerzbank’s reported non-performing exposure ratio stood constant across the two quarters at 0.8%. In addition, the bank highlighted that it has made further progress in reducing exposure to Russia, now at EUR 171m as of March 2024 and down from EUR 344m as of December 2023. 

Commerzbank has a relatively comfortable capital and liquidity position. The bank’s CET1 ratio is at 14.9%, with one of the largest buffers among European banks at 455 bps. The liquidity coverage ratio and net stable funding ratio are at 144.9% and 131.5% respectively in 1Q24, well above the regulatory requirement of 100%. Lastly, its highly liquid assets of EUR 140.6b covers for ~46% of its total deposits within Commerzbank.

Deutsche Bank

Deutsche continues to perform well entering 2024, with 1Q24 seeing a +1% YoY gain and a +17% QoQ gain in net revenue. Profit before tax also sees a good improvement – +10% YoY and +192% QoQ, although notably the 4Q23 results had to account for several one-off items in costs.

The good performance was primarily due to higher non-interest income observed for the quarter, rising by +9% YoY and +35% QoQ – offsetting a decrease in net interest income of -9% YoY and -3% QoQ. Deutsche commented that the +11% YoY growth observed for commissions and fee income was a result of the management’s objective to grow capital-light business areas.

Meanwhile, the gradual decrease in net interest income had largely been expected, owing to stabilising interest rates. The management emphasised its previous expectations for NII - to drop by ~EUR 600m YoY in FY24 but rise by ~EUR 400m in FY25 in anticipation of rollover of hedge portfolios and balance sheet growth. We believe this should be achievable in view of rates staying elevated, which should help to maintain DB’s profit outlook as the bank looks to improve its non-interest income. The net interest margin similarly reflects the drop in NII, falling gradually from 1.5% in 2Q23 to the current 1.3% in 1Q24.

On the other hand, costs have been well managed for Deutsche. Non-interest expenses fell by -3% YoY and also -3% QoQ, while adjusted costs (adjusting for litigation, restructuring and impairments) dropped by -6% YoY and -5% QoQ. As a result of the higher earnings and lower costs, Deutsche sees a large improvement in its cost-to-income ratio, from 71.0% in 1Q23 to 68.2% in 1Q24.

Asset quality for Deutsche saw some deterioration owing to more provisions made for Stage 3 loans. Provisions for credit losses are at 37 bps of average loans annualised in 1Q24, slightly above the FY23’s 31 bps and FY22’s 25 bps. Additional provisions were made for Stage 3 loans in 1Q24, driven by the commercial real estate portfolio in the Investment Bank and operational backlog in the Private Bank. Overall, Deutsche expects FY24’s provisions to be on the higher end of the 25~30 bps range.

Deutsche’s capital position remains decent, with the CET1 ratio at 13.4% as of 1Q24, as compared to 13.7% as of 4Q23. The drop in CET1 is due to the capital distribution and higher credit risk on risk-weighted assets owing to strong business growth. As of 1Q24, Deutsche’s CET1 ratio holds a 2.3% buffer over the maximum distributable amount requirement of 11.1%. The Group’s liquidity remains adequate, with a liquidity coverage ratio of 136%, a net stable funding ratio of 123% and high-quality liquid assets at EUR 219b (35% of total deposits).

Note – In late April, Deutsche announced that it is making provisions for a litigation case regarding the 2010 Postbank acquisition. Despite its disagreement with the court’s preliminary assessment, it is making a provision of EUR 1.3b (almost all of its 1Q24 profit after tax). Deutsche is still awaiting the final judgement from the court and may opt for a settlement before the final verdict. Moody’s stated that it does not expect the provision to affect Deutsche from attaining its 2025 financial targets, although it would likely affect the shareholder distribution trajectory.

Declaration: For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a position in CMZB 6.500% 24Apr2034 Corp (SGD), and the analyst who produced this report holds a NIL position in the abovementioned securities.