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How to separate the banking wheat from the chaff

Valuations reached all-time lows in 2020 on a price/book value basis

Like the global financial crisis, the pandemic led to change for the banking sector. Banks had to migrate towards digital at break-neck speed.  

Despite the huge constraints brought about by successive lockdowns, most banks managed to serve their clients thanks to their IT infrastructures.

In Europe in particular, they have been one of the key conduits of government support to households and corporates. Reported earnings indicate that banks in general were able to navigate the shock with (so far) limited casualties.

Despite this resilience, European banks’ listed shares are trading at low multiples in absolute and relative terms. In fact, valuations of banks reached all-time lows in 2020 on a price/book value basis.

Amundi’s investment intelligence team has put together a study paper, Banks in the post-Covid 19 World, making the case for the traditional banking sector in Europe and outlining who the winners and losers in banking will be in this post-pandemic era.

Low valuations

The paper points out that the main listed banks in the eurozone are currently trading at 0.7 times their tangible book value and below nine times next year’s earnings.

These low valuations imply that European banks’ returns will remain structurally below their costs of capital and that, in aggregate, the risks and costs of running these businesses overwhelms future profits.

However, the research team argues that there are significant valuation dispersions within the broader financial sector universe, with fintechs trading at high multiples whereas traditional banking has been penalised by a lack of investor interest. Essentially, there is a de facto premium for the disruptor versus the disrupted, which clearly shows that there is value in the sector.

The view from Amundi is that the lack of nimbleness and adaptability in an environment where tighter regulation hasn’t been balanced by larger revenue opportunities justifies the segment’s lack of attractiveness for investors – but not banking as a business per se.

As Amundi’s deputy chief investment officer, Vincent Mortier, explains: “We think that despite the identified challenges, the sector offers interesting investment opportunities on a selective case-by-case basis.”

Fintech factor

Christian Solé, deputy head of fundamental European equities at Candriam, takes a similar line.

“I would agree that some fintechs are trading at high multiples as investors expect high growth/returns. Yes, some fintechs are very agile and benefit from state-of-the-art technology (recent IT platforms, cloud, etc…). And they are grabbing sizeable market shares in some markets (Forex, payments).”

He adds: “Most banks have remained cheap due to the low-rate environment as this hurts their profitability: they cannot invest deposits with a decent margin. In addition, they have to invest massively for the transition from branches to digital banking while they have had to cope with increasing regulation following the 2008 financial crisis.”

On the other hand, Solé believes that the core of the banking business (deposits-loans) will remain regulated and can be profitable in markets with limited competition.

“Fintechs looking for deposits will also be regulated and this regulation will also serve as a barrier to entry in this market.”

He concludes: “In this Schumpeterian world, some banks will fail and some fintechs will succeed. This is why we also believe we need to invest on a case- by-case basis.”

Matthew Williams, head of global financials at Carmignac, argues that from this point on, individual bank fundamentals will dominate future share price performance with each bank being challenged on key questions.

“Will revenues beat expectations or miss? Will operating and credit costs out or underperform? Will regulators allow banks to return capital – via dividends and/ or buybacks? We agree the fundamental outlook for some banks is positive and the equity market is missing this. But we don’t see the sector as a whole as significantly mispriced.”

As for the future of banks generally, Mortier at Amundi insists that financial systems need banks to function properly, and he believes that the core purpose of banking, which is to safeguard client assets, gather and protect information and create money via lending, will be their sole prerogative in the future.

Winners and losers

So, what characteristic will define the winners from the losers in the banking sector over the coming years? According to Amundi, offering ESG savings and investments products will be essential.

‘Banks’ positions in the economic architecture mean they are the main (if not the only) conduit of ESG at the global level. The end use of money created, the impact of investments on climate change and social inequality are now of paramount importance for customers, shareholders, stakeholders and regulators’, the research paper says.

It adds that banks are, by nature, the gatekeepers of the ‘G’ of ESG, not only for big corporates but more importantly regarding small local businesses. Accounting rules and adequate decision-making processes are de facto cross-checked by banks in the lending process which has a governance role in credit creation.

Winners in this sector, according to Amundi, will also be banks that present scalable digital platforms. 

Digital per se does more good than bad, the Amundi paper argues, but to get the full benefit of the digital revolution, banks have to invest in new infrastructures (fewer buildings, more networks), different skills and talents, and change their operating models.

It adds that the overall labour and asset structures have to evolve in order to better fit this new framework.

‘Most large banks’ strategic plans are actually built around this and it is a misconception that large bank managements are in denial with regard to the changing needs.

‘Indeed, banking is the largest non-tech sector in terms of IT investments globally. It is in the implementation of these transformational plans that big banks in particular are struggling’.

Scalability

‘Big is not the solution, but scalability is a prerequisite for success in the digital world,’ Amundi asserts. ‘Efficient and innovative digital banking service providers will take significant market share probably beyond what we’ve seen in recent history.’

The asset manager’s research also indicates that successful banks will be those that use M&A to acquire technology and digital customers rather than engineer mergers as a means to cut costs.

As is the case for Big Tech, which has been acquiring fast-growing firms to protect and enhance core businesses (think of Facebook acquiring WhatsApp), Amundi expects banks will acquire fintechs and neobanks to maintain their competitive edge and increase the number of users on their digital platforms.

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