Interview with Philipp Wackerbeck, Partner at Strategy& Germany and Global Head of Financial Services for Strategy&
What is the general situation in the European banking sector? Is it prepared for a recession in the eurozone? What are the weak points and strengths of banks in Europe?
In terms of capitalization, but also regarding liquidity and other aspects, banks are in a fairly decent position. They've done a lot of improvement over the past 10 years. It's not just because they have more capital and of better quality. They have also improved risk management and capital management. In terms of risk management banks are more alert and, in a wider sense, also a bit more conservative. They are not as easily engaging in business activities they lack understanding for, like many banks in Europe did before the Global Financial Crisis.
What is the biggest problem of European banks?
The key problem is how they can achieve a sufficient profitability level. It's their major disadvantage compared to banks in the US or Asia. They are not earning their cost of capital, only a very few do. In most cases, Return on Equity is structurally lower than the cost of capital. Hardly any bank is earning the 9-10% you need to create some shareholder value. That's why they are trading below book value. We have some exceptions, largely in Scandinavia or Benelux, caused not only by the superior performance of the banks in those countries, but also partially by the oligopolistic market structure.
If you look at the map of Europe, where do you see banks are weaker or less prepared for problems in the economy? Italy? They were restructuring for years. And now the whole economy is at risk.
This is not that easy to answer because different countries are suffering from different risk factors more than others. For example, when the war in Ukraine started, obviously banks with larger exposures to Eastern Europe were the ones where initially there was more concern.
Looking at the NPL levels, they have come down fairly substantially. Four, five years back we were at an NPL volume of more than euro 1,000 billion in Europe. That has more than halved. NPL ratios of European banks have come down from more than 6% to 3% on average. Obviously the southern European countries and some Eastern European countries have a higher share of NPLs.
And in terms of capital?
It has been a fairly good development over the past couple of years. The banks are sufficiently capitalized to withstand the initial storm. The question is how deep the recession is going to be, what will be the impact on the economy of the rising interest rates. Some indicators are showing dangerous tendencies. In Germany, exports to non-EU countries have dropped by double-digit numbers in the last quarter. This is a sign that it's going to be more and more difficult. So, even in countries that did well like the Netherlands or Germany, we will see an increasing number of insolvencies and more NPLs.
What will be the ECB reaction?
Its sentiment seems to have changed quite significantly just over the past couple of weeks. Until mid of the year, the ECB was fairly relaxed about the situation, but now - as central banks really struggled to get inflation under control and interest rates may have to increase a lot faster and a lot more intensely than people have anticipated so far - it is a lot more concerned about the impact of a potential recession. The problem now is that fiscal policy and monetary policy can't do much to prevent it.
What will be the impact on banks?
It really depends on the magnitude of the recession. In one of the simulations we used the EBA stress testing methodology for the largest European banks with the current consensus on macroeconomic projections, it showed that the situation is still fairly manageable. But we also know that the market consensus for the macro projections is going down quite fast.
Will higher interest rates help banks in the eurozone? In Poland they did.
In principle it's very positive. Operating with negative interest rates and narrow spreads was really challenging for most of the banks. They had to be subsidized and now there will be no subsidies with those programmes like TLTRO that really pushed the balance sheets.
In most of the European countries banks are still largely dependent on interest income rather than fee income. But the impact depends on how quickly banks can adjust on the lending side versus on the deposit side. And it may be a bit challenging if interest rates increase too much too quickly because with variable loans on your mortgages, this will dampen the quality of your loan book. This is very different in countries lik Austria where it's largely variable rate in mortgages compared to Germany with largely fixed rates for 10-15 years.
With the war in Ukraine we see big problems in the natural gas market, in commodity markets in general. Which in the longer term will have an impact on energy transformation and attitude towards ESG in financial institutions. Do you expect that regulatory requirements on ESG could be relaxed?
Our current line of thinking is that regulation will stay intense in the ESG space. It will further intensify. There may be temporary relaxations in terms of classification depending on the impact of gas shortage for the population. But I think the direction of the bigger picture is very clear. Europe is very committed to taking this very seriously. However, the problem is that Europe has a more technocratic approach. It's regulation-driven and not market-driven.
Maybe the market was too slow.
Yes, but the result is European banks in terms of ESG are very much focused to first and foremost meet the regulatory requirements because they are very intense. There's a lot of data that is requested fulfilling the transparency requirements and so banks are focused on formalities rather than on the substance. This is different to other parts of the world where there's less ESG regulation or even no ESG regulation. That doesn't mean that the banks there don't do anything as a result. They receive push from the market. When you talk to banks in the Middle East for example, and we worked for some of them, they receive a lot of pressure from rating agencies, stock investors, bond investors and others around ESG strategies, ESG ratios and KPIs. The management attention they have to devote to ESG is almost the same as in European banks, but it's different - they talk more about the substance and the business impact while in Europe, it's more about meeting the regulatory requirements.
Perhaps it's just the first stage. You need to know where you are.
Looking at the US banks, they have started much earlier and approach ESG from a different angle. They think about: How can I make money with ESG? In Europe it's more like: How can I avoid losing money? That's why I think many CEOs and other bank management in Europe are a bit disappointed with their progress on ESG. They spend resources on meeting the regulatory requirements, not on business discussions. Of course, everybody is looking at Green bonds and being active here, but that's not the gamechanger. There are not many banks that have really developed compelling strategies on how they can really drive ESG forward to generate superior revenues. Another problem is many move into certain asset classes that look compliant. That has implications on pricing. You see margins in certain asset classes in renewable energy already squeezed. Everybody is running after the same type of assets rather than finding more intelligent ways to create extra returns with ESG. Europe has a great opportunity to become the global leader in ESG, but it needs to complement the more formalistic part with a more business related part.
Has the war in Ukraine influenced strategic thinking about the whole CEE region from the perspective of international investors, international banking groups?
Geopolitical risk was not really taken much into consideration in the past. Now that is changing. I don't want to downplay by any means what is happening now in Ukraine, but on a global level the biggest challenge of this century is the mounting strategic conflict between China and the US. This will also have profound implications on Europe. We do trade with both of them, and we are dependent on both of them. Many companies in Germany have 30% of their business linked to China and 30% with to US. If one country should declare 'if you make business with us, you can't make business with the other anymore' those companies will be facing big challenges. This has implications not just for the economy but also for the banks because they have large exposures to those companies.
In the CEE region the risk is higher. I'll give you an example. Poland has a great track record for near-shoring solutions. Financial institutions and other companies have been putting a lot of their mid-office and back-office there. There's not a discussion around relocating it from there. You get good quality for a decent price. You have really bright people working on that. You have the economies of scale. But it can be different with new investments. When you do the evaluation, you usually end up with a short list of countries. Typically Poland or a country like Lithuania or Slovakia comes out on top. But companies may decide 'at this point in time we can't do near-shoring in Poland or in Lithuania or even in Slovakia; we'd rather go to Portugal or Spain' to avoid both operational risks and possible criticism from their stakeholders.
And what about investing in a bank or in an insurance company?
I think the pattern is the same. The potential downside is valued higher than the potential upside. But it's also getting cheaper now. Every crisis is an opportunity. It has mostly been in history. If you are willing to take risks you may potentially benefit. Bank are more reluctant at the moment to take such risk. That is why even on the Western European level banks are struggling to do cross-border acquisitions, although the ECB has created a huge incentive in 2020. Until then, the ECB was not acknowledging the bad-will recognition. Now they do. Given that price book ratios of European banks are between 0.3 and 0.8 it's a huge financial incentive. But even now banks across Europe are hesitant and very cautious. Going into Eastern Europe, going into Poland, is obviously for somebody with a higher risk appetite and with less public pressure. For private equity this could be an interesting opportunity.
In Poland there's not much experience with private equity investors in banks. On the other hand, there's Getin Noble, a struggling bank, which might be a target for private equity because simply nobody in the banking sector is really willing to buy it.
I can't comment on individual cases. But I think in general there are examples of this kind of investments like Bawag in Austria or Hamburg Commercial Bank in Germany. There are really impressive turnaround stories on how the private equity owners have turned low-performing banks into really strong assets. Four years after having been taken over by private equity, Hamburg Commercial Bank is one of the best performing banks in Germany now with a Return on Equity of 20%, CET of 24% and a cost-income-ratio below 45%. Typically, private equity owners need to exit their investments after 5-7 years and thus they optimize the performance against that time horizon.
And what was the attitude of supervisors? In Poland that was one big obstacle for investing in banks by private equity.
This seems to be less of a problem. The respective supervisory authorities look at this in the ownership control procedure like for any other investor. Sometimes it might be more difficult even for a regulated bank investor from a more exotic country to buy a European Bank than for a sophisticated private equity investor.
How do you see Poland as a banking market? Is it attractive from the perspective of potential investors? We have quite a big market with a strong economy. But also we have banking tax, mortgage holidays, the share of state in the banking sector is over 50%.
When we do market entry strategies for non-European banks into the European market they ask what would be an interesting market to enter? It's not the UK anymore because you can't passport a banking license in the EU. Going to Germany has another challenge: the market is big but it's also very competitive and with low margins. In Poland, on the other hand, you have a fairly large, dynamic population. There's a growth story: you're still catching up with Europe. Also digital affinity is high. Many banks have done quite a lot of work in digitization and in the education of their customers. So by and large the Polish market is fairly attractive.
You listed the strong points. How do they compare with weaknesses?
The high share of state-owned banks is not always a disadvantage. In Turkey there is a high share of state-owned banks, but the private banks are performing very well against that. In Poland the question is on most recent developments like loan holidays. They make banks less attractive because that really has a P&L impact. In the short term, the geopolitical risk may be a bit of a showstopper. And things like the loan holidays make it even more difficult. In order to make Poland an even more attractive investment destination, it could be helpful to create an environment that is attractive for strategic investors, not just for financial investors that want to pick up something at a cheap price.
Original article in Polish on the Dziennik Gazeta Prawna website
