Making hay

Buttonwood

Feb 8th 2005
From The Economist Global Agenda

Most of Europe’s banks have been trading on lower multiples than their American rivals. Is it time to re-rate them?

BUTTONWOOD had a small sorrow recently. It involved a lock of hair. Before heading out to the long grass some years ago, she left various treasures at her bank for safekeeping. A decade later, these proved hard to recoup. After many months, the bank found one large manila envelope in a warehouse in the English Midlands—but not, alas, the one containing an apricot-coloured curl from first daughter’s first haircut. A spate of similar tales from friends prompts the suspicion that British banks, at least, are getting a bit stretched where customer service is concerned.

Not that you would know it from their 2004 results, which are beginning to come out now. Northern Rock, a building society-turned-bank, announced record profits late last month. That prepared the way for what promises to be a profits bonanza all round. On February 28th HSBC, Britain’s biggest bank though with thoroughly global operations, looks set to reveal profits as much as £2 billion ($3.7 billion) higher than the £9.8 billion figure from Shell a week ago that was hailed as the largest profit ever made by a British company. Altogether, Britain’s nine listed banks are expected to show after-tax profits £35 billion-40 billion higher than the year before.

They are not alone. Bank profits in continental Europe have also been buoyant. Deutsche Bank kicked off with a big increase in net profits for 2004. In the past week France’s BNP Paribas, Dutch ABN-Amro and Switzerland’s UBS have all reported sharply higher profits. In America, where most banks reported earlier, profits for money-centre banks, especially, were sharply higher than a year earlier. In both Europe and America, bank shares have outperformed their broader market indices.

In Britain, where the class struggle is not dead, just resting, this spate of profits has provoked complaints that banks are gouging their customers. It is true that some markets are more competitive than others. But banks are companies, and company profits around the globe have been booming. Like them, banks in most places have benefited from the strongest world economic growth in decades, low inflation and interest rates, and improving credit quality. Many have also cut costs and restructured, so volume increases in business have been moving through to the bottom line more quickly.

The tide is on the turn now, and banks everywhere will have to row harder to make for shore. “Banks rely on two basic sources of profit—maturity transformation (borrowing short and lending long) and credit risk (lending to borrowers who may pay you back),” as Andrew Smithers, an economic consultant, puts it. “Neither of them looks particularly bright this year, though a third source—commissions on market transactions—may hold up better in the short term.”

In America the yield curve has been flattening for some time, putting the squeeze on banks’ interest income. All the indications are that the Federal Reserve will continue to tighten short-term rates a little at a time. As economic growth eases, credit quality is still solid, but Standard & Poor’s, a rating agency, has warned that corporate credit could deteriorate this year. America’s heavily indebted consumers, too, could be vulnerable to any downturn in house prices. Merger and acquisition activity, however, is booming and will generate billions of dollars in commission income for banks and investment banks.

As for Europe, it is tricky to generalise, given the diversity within the region. Switzerland’s big wholesale banks are very different from Italy’s retail-oriented banks; and Germany’s universal banks have to contend with a distinctly earthbound domestic economy while France’s are beginning to cross-sell like mad to increasingly interested retail customers. As so often in matters European, Britain hovers offshore in a market that looks more American in its sophistication and indebtedness, but where most banks aspire to wield a universal clout like the continentals.

With this caveat, in Europe the picture is a rather different from that in America. Growth in the euro area is expected to be only 1.6% this year, compared with America’s 3.5%. (In Britain it is a brisker 2.4%.) Inflation has ticked up a trifle, but short-term interest rates are not expected to rise, so banks may find it easier to retain their net interest margins. And there is still scope for restructuring to push up profits: Deutsche Bank and ABN-Amro are among those that have announced plans. Except for Santander’s purchase of Abbey National last November, banks seem to be eschewing the megamergers that American banks have chosen, preferring to reshuffle their portfolios and add weight through modest deals. Concern over a sagging housing sector and increasing competition for corporate borrowers is beginning to rear its head—in Britain, especially—but all in all, Europe’s banks are in reasonable shape.

Ian Scott, the global head of equity strategy at Lehman Brothers, an American investment bank, is one who believes that Europe’s banks deserve a higher valuation than their American rivals this year. Most European bank stocks trade at a slightly lower multiple of estimated forward earnings than American banks do, once immigrant HSBC is taken out of the sector. They have also been less profitable than their American counterparts in recent years, with an average 14.5% return on equity in 2003 compared with the Americans’ 18.1%, according to Lehman Brothers. The gap narrowed substantially last year, however.

One of the main reasons why Europe’s banks look brighter these days is that retail customers are asking for more financial services from their banks, particularly in Spain and France. Why is this, if Citigroup’s spin-off of its insurance business is telling us that financial supermarkets don’t work? This is mainly a matter of history: in countries which separated different financial businesses by law or custom (America and, to a lesser extent, Britain), banks have found it hard to play as big a role in channelling savings as they do in other countries (Germany, France).

Mostly history, perhaps, but not entirely. Booz Allen Hamilton, a consulting firm, recently surveyed banks and their customers in six European countries and found that while on average 40% of Europeans would expect their bank to provide a wide range of financial products, only 20% did so in Britain. Branch staff were not very knowledgeable and the queues were too long. Room for improvement? Now, about that lock of hair…

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