Bank Balance Sheets Continue to Strengthen

Another day and another set of robust Q2-2021 bank earnings, despite the continued headwind of zero rates and flat curves. This earnings season began with impressive reports from the major US lenders, and their European counterparts have, thus far, followed suit by posting equally impressive results. UBS released blockbuster numbers last week (CET1 over 19%), and the trend continued this morning. Barclays announced a considerable rise in pre-tax profits of £2.58bn for the quarter. In addition, they reported a robust 0.5% increase in CET1 to 15.1%, representing a considerable headroom of 390bps above its maximum distributable amount (MDA), helped by the release of loan loss provisions totalling £797m.

Turning to mainland Europe, Deutsche Bank easily beat consensus estimates with a net profit of €1.06bn through higher revenues, lower costs and the release of loan loss provisions, which helped the lender to report a better than expected CET1 of 13.2% (albeit slightly down on the previous quarter). Meanwhile, Santander, which derives a considerable amount of revenue from Latin America and the UK as well as its domestic Spanish market, also comfortably beat estimates. It posted an 8% quarterly rise in net income to reach €2.1bn, with net loan provisions plummeting by 44% y-o-y. The Spanish lender also reported CET1 at 12.11%, higher than expected but slightly lower than the previous quarter. In common with Deutsche, the slight fall in CET1 was primarily due to the impact of TRIM (Targeted Review of Internal Model), the ECB's attempt to impose a consistent approach to Euro lenders' risk modelling. However, encouragingly the majority of the large Euro-based lenders are close to meeting their TRIM requirements, with the banks utilising strong earnings to address the issue where needed.

This is an active week for bank earnings, but the expectation is that balance sheets across the sector will remain overtly healthy. However, many analysts are now questioning whether Q2/Q3 will represent the peak for capital ratios. We know that distributions will flow again from the 1st of October (albeit under regulatory scrutiny), and the banks today all gave an upbeat outlook for their equity holders. For instance, Barclays announced a £500m share buy-back scheme and a higher than expected dividend of 2.0p.

We agree that banks are sitting with an abundance of excess capital and will use some of it to repay share-holder support. However, capital buffers will remain elevated for some time to come; recent quarterly bank surveys suggest despite banks' willingness to lend, demand from borrowers remains relatively muted. Therefore, unless demand for corporate and consumer lending significantly increases, the banks will see limited growth (if any) in their risk-weighted assets (RWAs). In addition, regulators are likely to remain protective of the transmission mechanism and will continue to scrutinise distributions for the foreseeable future. In our opinion, these factors are likely to result in limited movement in retained earnings. Hence, we may well see CET1 ratios remaining at the higher end of target ranges, which can only be good from a bondholder perspective.      

The next catalyst for banks must be rating changes, both in methodology and individual assessments, particularly considering the level of recent AT1 issuance. The ratings of those banks that reported today all sit below investment grade, with Barclays's receiving a lowly B+ rating from Standard & Poor. In our opinion, the rating agencies' assessment of bank capital is out of synch when compared to their evaluations of the less-regulated corporate universe in high yield.