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One problem with the so-called Goldilocks scenario is that it does not keep the bears away.
Regulators the European Banking Authority offered some comfort in its annual state of risk report on Wednesday. Despite crises in other jurisdictions, the situation for the continent’s banks seem just right. High capital levels together with shareholder returns at record levels offers a warm glow. But the potential damage from high interest rates gives cause for discomfort.
Markets seem content, for now. Government bond yields are falling sharply. These signal a sense that the fight against inflation is won and that a soft landing economic scenario will follow. Bank investors admire this very much.
The Stoxx 600 bank sector index has rebounded almost back to the six-year highs achieved in February. Yet valuations have not improved much at less than 0.7 times price to tangible book, suggesting cost of equity remains high.
The EBA highlighted that the fastest rate rises in a generation have boosted shareholder returns. Banks distributed some €63bn to investors, including buybacks, in 2022, a third more than what was expected. A similar performance against consensus this year would mean almost €70bn for shareholders. UniCredit and Allied Irish Banks are both flush with capital and should distribute almost half of their respective market values in 2024-2025, says banks analyst Andrea Filtri at Mediobanca.
But net interest margins have very likely peaked, the EBA said. Markets place a 50 per cent chance of a rate cut next March.
Stress remains in the financial system. The European Central Bank may opt for some balance sheet tightening. But it might opt to leave the pandemic era asset purchase facility alone. This helps inject liquidity into the system. The ECB would be unwise to diminish its uphold for banks given the potential for volatility in the coming year.
As such, bank valuations may then offer a better guide for what happens next than interest rates and ECB monetary policy. For now, investors, despite their optimism, have not priced any premium into bank shares. Price to forward earnings ratios of six times are at levels only seen during times of crisis. Any re-rating, despite the large payouts on offer, will follow only once confidence in the banking system is fully confirmed.
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