RBS is recommending a cautious stance on Spanish banks on Monday.
It’s nothing to do with provisioning for legacy assets or impairments, however.
Like UBS analysts before them, the RBS move is down to diminishing new business margins — and an increasing cost of funding — which, it seems, are pushing Spanish banks increasingly into the shorter-term end of the funding market.
In a sense, Spanish banks may be being forced into the Northern Rock funding model.
According to RBS, core banking new business margins contracted ‘meaningfully’ over 2010 thanks to the domestic deposit war and the rise in wholesale funding costs. For Bankinter, Sabadell and Banco Popular, the new business margin actually turned negative in November. Santander and BBVA’s domestic margins, meanwhile, have dropped from about 2 per cent to some 0.8 per cent in the same period.
While the move towards short-end funding may be designed to bolster the bottom line — especially for those banks which purposely focused on new business margins to drive profits — RBS sees the move as ultimately unsustainable. Mostly because it is too dependent on cheap funding from the European Central Bank.
As they put it:
Sustained term wholesale prices at current levels would likely force small players to avoid term debt issuance through shortening funding maturities. Whilst this could be P&L beneficial in the short term, it requires a continuing accommodative stance from the ECB and Bank of Spain. This is also likely to keep competition for domestic deposits high.
Consequently:
We cut our earnings estimates to reflect new business margin
Our new business margin analysis implies a steeper fall in backbook margins than we had previously factored in for the sector. For the domestic-only banks and BBVA, we cut our EPS estimates by c10% for FY11F and c20% for FY12F. This reflects our analysis of worsening core banking new business trends. For Santander, we have cut EPS by 3% and 4% for the same respective periods.
We remain cautious on the outlook for Spanish banks’equity prices
The recent euphoric sector share price rally off the back of successful sovereign debt issuances for Portugal and Spain last week is unsustainable in our eyes, unless the wider mandate for any European rescue fund includes a bad bank option or the ability to provide short-term credit to sovereigns with liquidity problems. The material structural issues facing Spain and its banking sector remain the same. We retain our cautious stance on this sector.
But what’s also interesting is that RBS believes Spanish banks will suffer on the back of the domestic deposit war they waged over the last year too.
After all, corporate depositors are now fully aware of the value of their own excess liquidity and will not tolerate changes to deposit terms well.
Nevertheless, back to new business margins — the below chart shows the degree to which margins have now slipped for all Spanish banks:
Once in negative territory, of course, there are additional issues too.
‘Extend and pretend’ becomes increasingly meaningless, according to RBS, since there’s only a benefit to the bottom line if a bank can secure a positive margin on the mortgage novation or modification arranged (usually for the purpose of keeping their customers’ existing debt repayments afloat). And that’s increasingly unlikely.
As RBS notes:
There are clearly management strategies that have helped to protect P&L as interest rates have fallen over the last two years, mainly active asset and liability management through increasing ALCO bond portfolios. However, such low profitability within the core banking business for each bank is unsustainable, in our view. So, over time, we would expect higher wholesale funding costs to be passed on to customers. Otherwise, we are back to our options laid out above to combat higher wholesale funding costs, or else weak players will be forced to sell themselves to scale players (probably without takeover premia).
However, banks seem unable or reluctant to directly control new business pricing at this time. It is difficult to explain how banks can continue to offer new mortgages at 2%, based on a Euribor 1- year benchmark with a 50bp to 80bp margin, whilst the funding via a covered bond would cost them 4%+. This new business analysis is also replicated in the actual RoA and RoEs for the sector in Charts 3 and 4 above.
And it’s not just RBS noticing the problem.
UBS cautions on the very same thing (yet again) on Monday too:
Unattractive risk-reward profile
We remain cautious on Spanish banks because of ongoing [net interest margin] contraction and the asset quality risks embedded in their domestic businesses, which in our view are not reflected in market valuations (domestic players in line with sector and Santander/BBVA on substantial premium – based on P/B). We are 15-20% below consensus in most Spanish banks. In this report, we preview Q4 10 results.Structural challenges for NII becoming more visible in Q4 10
We think that the need to reduce commercial funding gaps and extending funding maturities will lead to long lasting deposit wars driving more NIMs pressure. Rising short term rates should also impact carry trade returns and produce temporary negative impacts on mortgage margins (to be recovered over time). We see these factors driving NII consensus downgrades in coming quarters incl. Q410.
Although both analyst teams agree that thanks to its regional diversification Santander will weather the domestic margin slump — which is apparently ‘dramatic’ on its Spanish book — better than other regional competitor banks.
So thank goodness for all those Santander M&A deals. Very clever.
Related links:
The sovereign ‘Northern Rock’ funding model - FT Alphaville
That extended España RMBS - FT Alphaville
BBVA, an exercise in Spanish banking losses – FT Alphaville
Spanish banking crises, then and now – FT Alphaville