European Banking Outlook

Conducted by Standard & Poor’s

Fifty leading banking groups in Europe have been assigned a solid ‘A+’ to ‘AA-‘ average rating. The ratings indicate strong creditworthiness of banks. However, the performance and prospects of banks vary considerably. The Standard and Poor (S&P) long-term rating for the majority of the 50 largest banking groups is stable.

However, the rating for 18 of the 50 largest groups is negative, due to complex domestic markets, decline in investment banking returns and increasing risk charges outside home markets.

On the contrary, 4 financial institutions including UniCredito (A+/Positive/A-1), Sanpaolo IMI (A+/Positive/A-1), Natexis Banques Populaires (A/Positive/A-1), Credit Lyonnais (A-/Positive/A-2) have positive positions because of development in their financial profiles, along with that of the domestic markets. Germany is the most difficult banking market in Europe, having half of the troubled banking groups.

Comparing 2001 & 2000 results

A comparison of two-thirds of the 50 banking groups, which published their reports, reveal that the pre-tax income of these banks during 2001 was moderately lesser than that in 2000. Retail banking showed good results, but there was a downward trend in revenues from corporate finance, asset management and equity lines of investment banking.

Provisions for loan losses increased for majority of the banks, though the average increase was moderate. The largest losses were contributed by problems outside home markets, such as Argentina, Enron and the high-yield market in the US. Italian banking groups were most affected by these problems, resulting in a decrease in their rating.

The net new provisions in loan losses to average loans ratio grew to an average of nearly 60 basis points as reported by 33 of the 50 top banks. The average annual rate of provisioning comprises a significant measure of the trend of asset quality in Europe. The current provisions rate is less than half when compared to 1991-93, which was the most complex period in recent decades.

Outlook

The ratings assigned by S&P account for the downtrend in financial performance, which is unavoidable in the slow growth environment. Thus, most European banks will be able to maintain their current rating levels, despite simultaneously observing low performance.

Though the credit risk provisions are expected to increase across Europe in 2002, S&P does not predict a recurrence of the 1991-93 recession due to the following reasons: -

- The economic downturn will be milder
- Banks are less exposed to commercial real estate market
- The debt service burden on borrowers is reduced due to lower interest rate atmosphere
- Banks have shifted to retail business; some of the corporate risk is thus moved to bond markets
- Banks are making better use of portfolio methods in credit risk management

Trends in Retail Banking Sector

Retail commercial banking in most European countries, comprising the consumer and small and midsize business sectors, has turned around into a profitable business. While Italy and France showed the highest performance, Germany’s private sector banks could not manage to achieve even break-even performance.

Performance primarily improved due to reduced costs, streamlining networks and providing a wide range of products. The massive consolidation process also contributed to the achievement. The key domestic banking markets in Europe can be classified into three groups.

Healthy and Profitable Markets

The margins and returns on capital in the first group of markets are generally high, particularly in United Kingdom, Sweden, Spain, Denmark and Ireland. The ratio of overhead to revenue is better due to the cost controls implemented in these countries over the years.

The domestic market of Spain is among the most profitable in Europe. The conservative policies of the Bank of Spain ensured that banks raised their loan provisions level much above their problem loans. Banks in Sweden and Denmark have attained extensive economies of scale from consolidation. They have also applied state-of-the-art technology to deliver retail banking services.

The UK, Spain and Ireland also maintain a sound domestic market though they had to cope with low housing prices.

M&A activity improved the leverage in some banking groups, which ultimately gave high returns to shareholders due to optimally utilised capital. For instance – the merger of Royal Bank of Scotland (AA-/Stable/A-1+) and National Westminster Bank (AA-/Stable/A-1+) in the Royal Bank of Scotland Group reflects a remarkable cost saving strategy.

Restructured Markets

The second group countries, Italy and France, have completely refurbished their fundamentals. In the mid-1990s, the banking sector in these countries was under recession. However, they are now in a better position to manage any economic crisis.

The Italian market has shown significant development through mergers and acquisitions and the pace of modernisation. Two major groups, UniCredito and Sanpaolo IMI have reflected dynamic growth on par with their peers.

The French retail banking sector has also achieved a steady turnaround and is now ranked among the top half in Europe. For example Credit Lyonnais and Credit Industriel et Commercial are now assigned ‘A/Positive/A-1’.

Sick Markets

The last group consists of countries having difficult operating environments such as Germany, Netherlands and Austria.

Germany’s banking sector with its excess capacity is the most vulnerable. The German domestic market is dominated by non-profit savings and cooperative banks. The pre-tax profits of German banks for the year 2001 will be considerably lower than those for 2000. Most German banks have been assigned negative ratings.

Private sector banks have also failed in their consolidation attempts over the past two years. In their effort to grab wholesale corporate and investment banking markets outside Germany, the private sector and Landesbanks achieved only moderate results. The ratings of Bayerische Hypo-und Vereinsbank (A/Stable/A-1) and Commerzbank (A/Negative/A-1) were recently downgraded.

The Landesbanks are likely to continue receiving strong support from the state governments over the years. However, S&P predicts that the required improvements may not be implemented due to conflict of interests between the banks’ owners.

Netherlands is also one of the toughest markets in Europe, though the scenario here is not as bad as that of Germany. Dutch banks have developed from their relatively small and mature home market through expansion diversification. This has had mixed results on their profitability and risk exposures.

Beleaguered Corporate and Investment Banking

European banking groups, which have expanded their corporate and investment banking businesses recently, are the most effected due to global economic downturn and fall in equity markets. The worst hit are the banks’ international operations in wholesale corporate banking, investment banking. The retail commercial business also suffered, particularly due to exposure to Argentina.

Corporate and investment banks showed a downward trend in their performance in the second half of 2001, compared to the first half. Corporate finance, including equity underwriting, M&A advisory, venture capital and equity brokerage performed badly.

Low equity prices, and limited growth in revenues from percentage-based fees in private banking and asset management led to reduction in investment portfolios of clients. More over, losses from Enron, the airline and telecommunications industries added to the blow.

Investment banking returns are directly linked to the market situation. Groups that added costs mostly from acquisitions, such as the purchase of Donaldson, Lufkin & Jenrettee by Credit Suisse Group in August 2000 are now facing difficulties in managing the overheads in less favourable markets.

According to S&P, among the banks that developed international corporate and investment banking businesses, Credit Suisse Group (AA-/Negative/A-1+), ABN AMRO (AA/Negative/A-1+) and Commerzbank (A/Negative/A-1) are under pressure and their long-term ratings have been downgraded. Deutsche Bank (AA/Stable/A-1+) and UBS (AA+/Stable/A-1+) are also facing heavy costs but are better positioned from their peers.

Decline in operational efficiency

The European commercial banking business has gradually improved its efficiency but the operations efficiency of corporate and investment banking has been disappointing especially in 2001.

A comparison of the 41 largest European retail commercial banking groups and 9 corporate and investment banking groups over a period of 8 years from 1994-2001 shows that while the former group has reduced their average cost-to-income ratio by over 6 percentage points, the latter increased it by around 7 percentage points during the period.

Among the large and profitable retail operational groups, BNP Paribas (AA-/Stable/A-1+) and Barclays (AA/Stable/A-1+) reflect low and improving operating leverage.

Corporate and investment banking businesses are cost intensive and difficult to manage through market cycles. S&P predicts a low business during 2002 for these groups. Basically, the capacity to manage cost and single-party concentrations plays a key role in assigning ratings to corporate and investment banking groups.

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