European banks still facing many headwinds

The poor investment returns European banks have generated since the Great Financial Crisis is likely to continue for the foreseeable future warns Jacob Vijverberg, co-manager of the Kames Diversified Income Fund.

Vijverberg says if you had invested €100 in European banks in 2009 it would only be worth around €120 now equating to a measly 1.5% return per year, with even German Bunds posting better returns at around 3.5% a year over the same period. And unfortunately for investors, he predicts this poor rate of return is set to continue as they face a number of headwinds.

First, Vijverberg points to the raft of new regulation banks have faced since the GFC which has seen the high capital requirements erode their return on capital. He says: ‘The increase in capital ratios, making banks more resilient in times of crisis, whilst positive for depositors and taxpayers, means a lower return on capital for investors. Banks are earning approximately the same return on their assets as pre-GFC but the returns now have to be spread across a higher capital base.’

Another headwind he highlights is the stiff competition the banks face. He says: ‘Europe is also over banked. Whatever metric you use, branches, employees or loans as a percentage of GDP, Europe has too many banks competing for the same clients, resulting in pressure on fees and interest income.

‘The banks also face competition from nimbler fintech companies which have had little impact so far, but are likely to gain traction partly thanks to new European regulations.’

The banks are also facing pressure on their interest margin, with the rates they pay on their liabilities (mainly deposits) and those they receive on their assets (loans and mortgages) narrowing.

Vijverberg says: ‘Many banks have realised the precarious situation they are in and are looking for other sources of income with many shifting towards fee paying business which does not require capital, such as financial advice or asset management, but here to profits are limited or already shrinking due to technology, regulation or focus on costs.’

Concluding, Vijverberg adds: ‘Clearly financial markets have realized the banks have some problems and the sector is therefore trading at low multiples but structurally we expect bank equity will underperform despite its cheap valuations. We are therefore very selective in our exposure to the sector and despite these concerns there are several banks bucking the trend by generating higher returns on equity due to lower cost ratios, due to better online offerings.’