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The State of Banking:Still Unstable Macro Credit Research

Bloomberg FI14 Forum, June 2014Alberto Gallo, CFA

Head of European Macro Credit Research

+44 (0) 20 7085 5736alberto.gallo@rbs.com

Lee Tyrrell-HendryMacro Credit Analyst

+44 (0) 20 7085 9462lee.t.hendry@rbs.com

Shikhar SethiMacro Credit Analyst

+44 (0) 20 7085 6479shikhar.sethi@rbs.com

Tao PanMacro Credit Analyst

+44 (0) 20 7678 3122tao.pan@rbs.com

Rajarshi MalaviyaGaurav Chhapia

Chanchal Beriwal

2

QE

Why do banks exist?

1. To optimally allocate resources in the economy

2. To borrow short-term and lend long-term

3. To promote new businesses and growth

4. To provide safe savings for depositors

5. To generate sustainable profits for shareholders

3

QE

Source: Google Books, Ngram

Viewer

Tulip-mania

1929 crisis 2008 crisis

The original sin of European bankingFrequency of the words “debt”

and “sin”

in English language books

4

Source: RBS Credit Strategy, Wikipedia

Of that seventh circle, where the mournful tribe

Were seated. At the eyes forth gush’d their pangs,

Against the vapors and the torrid soil

Alternately their shifting hands they plied.

Thus use the dogs in summer still to ply

Their jaws and feet by turns, when bitten sore

By gnats, or flies, or gadflies swarming round.

Noting the visages of some, who lay

Beneath the pelting of that dolorous fire,

One of them all I knew not; but perceived,

That pendent from his neck each bore a pouch

With colours and with emblems various mark’d,

On which it seem’d as if their eye did feed.

The Divine Comedy, Inferno XVII

5

Banking: a for-profit business or a social and political activity?

Source: RBS Credit Strategy, Wikipedia

Charging interest was sinful for the Catholic Church since Pope Leo the Great

The Lombards started loans on collateral, which was not forbidden. Lombard credit spread throughout Europe

Italians became famous bankers: the Medici Bank (1397-1494) was the largest banking institution in Europe

To fight lending at high interest rates and usury, the Franciscans created the mount of piety,a charity institution to lend at modest rates. They also spread throughout Europe

Germany’s landesbanken and sparkassen, Italy’s popolari and cooperative, Britain’s building societies and Spain’s cajas all have ties to local authorities and a high percentage of public ownership and/or non-negotiable control

6

0

10

20

30

40

50

60

70

52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12

US GDPUS c redit market debtEuropean credit m arket debt

Com petition & credit control introduced / Bretton Woods breaks down

Big Bang (UK) Glass-Steagall Act repealedFinancial crisisQuantitative eas ing

$tn

Half a century of credit supercycle

Source: RBS Credit Strategy, ECB, FRED, Bloomberg

You are here

?

7

Bank capital is at a record low

Source: RBS Credit Strategy, FDIC, Historical Statistics of America

0%

10%

20%

30%

40%

50%

60%

70%

1834 1844 1854 1864 1874 1884 1894 1904 1914 1924 1934 1944 1954 1964 1974 1984 1994 2004

Book value of equity / total assets for US banks

8

1. Restarting Europe’s credit engine

2. Fixing the banks (TLTRO, AQR, stress test)

3. Boosting non-bank lending (Credit Easing with ABS)

Source: Google. No animals were harmed during the making of this

slide

QE

4. The exit show: QE, asset bubbles, macro-pru for the US and UK

9

1. Restarting Europe’s credit engine

Source: Google. No animals were harmed during the making of this

slide

QE

10

Source: RBS Credit Strategy, Bloomberg

Bubble Crunch

StabilisationRe-leveraging

A cycle of four phases1. Crunch

GDP↓↓, π↓↓, D↑↑, M&A↓↓

2. Stabilisation GDP↓, π↓, D ↓↓, M&A ↓

3. Re-leveraging GDP↑, π ↑, D ~, M&A ↑

4. Bubble GDP↑↑, π ↑↑, D ~, M&A ↑↑

GDP = real growth

π

= inflation

D = default rates

M&A = M&A

activity

The credit cycle: Europe stabilising, US re-leveraging, EM crunch

Europe is stabilising, the US re-leveraging, EM are in an early crunch

11

Still the largest banks in the world

0%

100%

200%

300%

400%

500%

600%

700%

Irela

nd

Cyp

rus

Sw

itzer

land UK

Fran

ce

Eur

o A

rea

Spa

in

Sw

eden

Den

mar

k

GIIP

S

Aus

tria

Ger

man

y

Finl

and

Italy

Can

ada

Nor

way

Aus

tralia

Japa

n

Slo

veni

a

US

Bank assets % GDP 10-years ago

Source: ECB

12

Banking systems: Euro area vs US

Source: RBS Credit Strategy, Bank of Italy, ECB, IMF, World Bank, FRED

6,790 - Number of banks - 5,783

3.1x - Bank assets/GDP - 0.8x

37 - Number of branches - 35 per 100,000 adults

22% - Bonds/total debt - 52%

16% - Mkt share of top 5 banks - 33%

€1,041bn - NPLs - $200bn

10.9% - NPLs/GDP - 1.2%

USEuro area

13

The good news: Bank deleveraging is stabilising

0.0

-0.1

-0.2-0.02

-4.1

+0.2

-0.9

-0.5

-0.4-0.6

-0.6

-0.6 -0.3-0.2

-0.3-0.1

-0.03-0.1-0.2

-5.0

-4.5

-4.0

-3.5

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

Jun-12 Dec-12 Jun-13 Dec-13 Total

+0.3

+0.1+0.1 +0.2

+0.4

Deleveraging has stabilised: monthly total asset deleveraging in

the eurozone, €tn

Source: RBS Credit Strategy, ECB

14

The problem: Financial fragmentation is still high

Financial fragmentation impairs the transmission mechanism of monetary policy

The solvency gap Non-performing loans, %

Source: RBS Credit Strategy, Bloomberg

Unemployment rate and growth gap between core and periphery continues to widen

The funding gap SME average loan rates, %

Source: RBS Credit Strategy, Bloomberg

The employment gap Unemployment rate, %

Source: RBS Credit Strategy, Bloomberg

4%

8%

12%

16%

20%

07 08 09 10 11 12 13 14

Periphery

Core

3%

5%

6%

8%

07 08 09 10 11 12 13 14

PeripheryCore

0%

5%

10%

15%

20%

07 08 09 10 11 12 13 14

Periphery

Core

15

The bank job: Fixing Europe’s banks

Source: Google. No banks were harmed during the making of this slide

16

Lessons from the crisis

0%

5%

10%

15%

20%

AIB

Ang

lo

NBG

Ban

kia

Am

ag

Mon

te

HB

OS

ML

BoI

WaM

u

B&B

Wac

h

Nro

ck

SN

S

UBS

Dex

ia

Losses as % initial loans Losses as % init ial assets

Source: RBS Credit Strategy, ECB, Bloomberg

17

Lessons from the crisis

Source: RBS Credit Strategy, ECB, Bloomberg

0%

5%

10%

15%

20%

BB

VA

Inte

sa

KB

C

Rab

oban

k

Uni

cred

it

San

tand

er

Lloy

ds

Nor

dea

Cre

dit A

g G

roup

UB

S

ING

Ban

k

BN

P

CS

Soc

Gen

AB

N

Dan

ske

CM

ZB

DB

Bar

clay

s

3% requirement

average loss for bad banks

18

Capitalism without capital

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0 200 400 600 800 1,000 1,200 1,400 1,600 1,800 2,000

Credit Ag

HSBC

BNP

DB

Barc laysSoc Gen

Santander

BPCELloyds

UBSNordea

CS

U niCredit

ING

BBVA

Intesa

Rabo

SHBSEB

Poholja

LBBW ABN Danske

Nwide DZDeka Natixis

Source: RBS Credit Strategy, Bloomberg, company filings

The inverse relationship between RWA % (Y) and bank size, €bn (X)

19

Too big to fail has not gone awayBank assets % GDP

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

Dan

ske

UBS C

S

ING

Ban

k

San

tand

er

Rab

oban

k

HS

BC

Cre

dit A

g

BNP

Bar

clay

s

SEB

DB

KB

C

Soc

Gen

Uni

cred

it

BES

RZB

JPM

BAC C

iti

GS

MS

Source: RBS Credit Strategy, Bloomberg

20

Interconnectedness: Cross-holdings in Europe’s banking system

Source: RBS Credit Strategy, Bloomberg, company filings. Red = bank, Grey = sovereign, Blue = other

2.8%

Mediobanca8.7%

UniCredit

Generali

12.5%Intesa

Monte

Groupama 4.9%

Mediolanum3.5%

Credit AgricoleSocGen

1.0%

Natixis AM

AXA 1.0%

BNP

6.9%6.0%

Toro

1.4%1.3%

100%

JP Morgan

2.5%

0.15%

1.3%

2.4%

4.5%

Libya

2.6%

SantanderCredit Suisse

4.5%

France 2.45%

Deutsche Bank1.7%

0.06%

Commerzbank

0.12%

Allianz

Germany

Italy

17%

0.03%

2.5%

1.4%

Bankinter

1.6%

1.3%UBS

Singapore

6.4%

Norway

4.0%

BBVA

0.5%

6.5%

Abu Dhabi

BES10.8%

POP

4.1%

State Street

0.41%

Caixa Geral4.76%

Portugal Telecom

0.16%

10.1%

Telefonica

RepsolCaixabank

3.2%

12.21%

5.6%

5.75% CRH3.9%

Veolia

5.16%

IberdrolaQatar8.2%

Gas Natural

Caixa Holdings

35%

1.7%

BlackRock3.7%

21

0

10

20

30

40

50

60

70

80

Museums High schools Secondaryschools

Primaryschools

Pharmacies Kindergartens Hotels Bankbranches

Costs are still highNumber per 100,000 population, in Italy

Source: OECD, Bloomberg

22

A two-tier banking system

Source: RBS Credit Strategy, Bloomberg

Return on equity vs

credit rating (bubble size indicates amount of total assets)

-15%

-10%

-5%

0%

5%

10%

15%

20%PLC Investment banks Cooperatives/Savings banks

AA A BBB B CCCBB

RoE

23

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

22%

24%

26%

NK

BM

AB

LVA

poB

ank

DZ B

ank

Jysk

eB

CE

EC

rédi

t Mut

NL

BO

VB

Baw

ag

SID BP

IC

ata

luny

aB

ayer

nLB

Pir

aeus

BK

IRLl

oyds

Alph

aH

SB

CS

ydba

nk

LBB

W AIB

Per

m.

TSB

Dek

aBa

nkU

nica

ja DB

SE

BC

red

Ag

Grp

Bar

clays

Ban

kinte

rS

NS

Ban

kS

abad

ell

Dan

ske

Med

ioba

nca

Caix

aban

kB

ank

iaA

BN

AM

RO

San

tand

erIN

G B

ank

BN

PB

oVa

lletta

NC

G B

anco

BB

VA

Erst

eNo

rdea

Inte

saSo

cGen

Eur

oba

nkP

ohjo

laA

area

lR

abo

bank

DN

B N

orP

opu

lar

SH

BK

BC

UB

IR

BI

Lib

erb

ank

HS

HC

MZB

Ibe

rcaj

aA

rge

nta*

Sw

edb

ank

Bk

of C

ypru

sK

utx

aba

nkB

CP

RZB

Lan

d Be

rlinB

PC

EB

ES

Pop

olar

eU

niC

redi

tB

MN

LBW

FN

BGC

'mar

/ B

CC

BPI F

ranc

eR

NW

*R

LB

Hel

aba

Iccr

ea*

CE

ISS

BP

ER

Cre

dEm

CX

GD

BP

Son

drio

BP

Vic

enza

Cre

Val

Helle

nic B

ank

Nor

dLB

*N

ykre

dit

IKB

Be

lfius

Ven

eto

BP

Mila

noM

unic

h Hy

poM

ont

e P

asc

hiW

GZ

Car

ige

CT1 loss on non-periphery sovereign widening (after earnings and dividends)CT1 loss on periphery sovereign widening (after earnings and dividends)CT1 loss on NPL rise, 50% coverage rat io (af ter earnings and dividends)Earnings (80% of 3y PPI net of cash dividends)CT1 capital af ter st ress, before earnings

Bank CT1 ratio after estimated NPL shocks, and widening of sovereign bond yields over 3 years under EBA’s

adverse scenario

Stress test: Mid-sized banks vulnerable to rising NPLs and bond spreads

Source: RBS Credit Strategy, company filings, Bloomberg, EBA. Sovereign holdings data is from the EBA, and is as of June 2013.

Notes: We use FY 2013 results for the banks or the most recent filings available (marked with a *). We do not take into account measures to improve capital ratios post 31 December 2013. To translate the EBA’s

adverse scenario into an NPL shock, we regress the change in NPLs

over change in real GDP, unemployment and house prices during the crisis and adapt it to the EBA assumptions. If sovereign holdings data from the EBA is unavailable we use the national average. If EBA data is not available for any bank from

a country, we use the periphery or core average, depending on the bank’s location. We stress the AfS

and HfT

portfolios of banks only, proxied

as 70% of gross direct long positions. 3y PPI is 80% of average pre-provision income in 2011-13 less 80% of average cash dividends paid over 2011-13, as % of RWAs; The capital ratios are measured against each bank’s own reporting standards, typically Basel 2, 2.5 or the German Solvency standard for the Landesbanks

(note the EBA tests will use transitional CET1 ratio definition

under CRR/CRD). IKB and Belfius

have negative earnings so we reduce remaining CT1 capital to adjust for this. The EBA will use 8% and 5.5% capital threshold for its

baseline and adverse scenario of the stress tests. The above sample has banks which are included in the EBA’s

sample list: the EBA list has roughly 25 more banks than our current sample. The weak German banks in our test have reasonable initial capital levels, but lose out due to high holdings of bunds.

WeakerStronger

at risk+ = Capital after the exercise

24

Stress test: The bottom 30 in our adverse scenario simulation

0%2%4%6%8%

10%12%14%16%18%20%22%24%

BE

S

Pop

olar

e

Uni

Cre

dit

BM

N

LBW

F

NB

G

C'm

ar/ B

CC

BPI

Fra

nce

RN

W*

RLB

Hel

aba

Iccr

ea*

CEI

SSB

PER

Cre

dEm

CXG

DB

P S

ondr

io

BP

Vice

nza

Cre

Val

Hel

leni

c Ba

nkN

ordL

B*

Nyk

redi

t

IKB

Bel

fius

Ven

eto

BP M

ilano

Mun

ich

Hyp

o

Mon

te P

asch

i

WG

ZC

arig

e

CT1 loss on non-per iphery sovereig n widen ing (after e arnings and dividends)CT1 loss on periphery sovereign widening (after earnings and dividends)CT1 loss on NPL rise, 50% cove rage ratio (after earnings and dividends)Earnings (80% of 3y PPI net of cash dividends)CT1 capital after stress, before earnings

Stronger Weaker

+= capital after the exercises at risk

25

The economics of a TLTRO loan

Source: ECB, RBS Credit Strategy estimates

0

5

10

15

20

25

30

35

Gross interestincome

Normalfunding costs

TLTROsavings

Cost of capitalon loans

Cost ofprovisions

Fixed costs Net interestincome

Bas

ed o

n a

€1,0

00 lo

an

Loan yield = 3%TLTRO cost

= 0.25%

Normal funding cost = 1%

SME loan RWA is 75% (8% capital

charge)2% default rate, 40% recovery

0.5% cost

0.6% RoA

Savings= 0.75%

26

TLTROnomics: Boosting profitability but not if default riseReturn on equity of a TLTRO-funded loan for a given default rate, %

Source: RBS Credit Strategy

-5%0%5%

10%15%20%25%30%35%40%45%

1% 2% 3% 4% 5% 6% 7%

Core bank (lending at 3%)Periphery bank (lending at 5%)

Annual default rate

Ret

urn

on E

quity

Economic break-even default rates

27

30%

€29bn

€4.1tn Deleveraging by Eurozone banks so far

Will come from large banks

70% Of that will come from small banks

Capital needed by large European banks

€1tn Further deleveraging we think is needed

€374bn Decline in non-fin corporate loans so far

We assume that 80% of capital requirements will be met by raising fresh capital or through earnings for large banks, and 20% from shrinking assets. For small banks, we assume 60% of capital requirements will be met by raising fresh capital or through earnings, and 40% from shrinking assets.

28

Source: RBS Credit Strategy, BBG, Company filings

Crisis cost

bank losses capital=[ - ( + bail-in backstops+ )] x size of

system3%

leverage ratio 8% of

total liabilities€55bn

SRM fundbanks lost

2%-13% of

total assets in

previous crises

3x GDP

= 5.8% capital / assets

A formula for financial stability

29

QE

Cocos: are you a lover or a hater?

1. I am buying them for yield

2. I think conversion risk is unlikely

3. I am buying them because of lack of alternatives

4. I think they are fundamentally cheap

5. I will never buy them!Source: Google images, Marmite

30

Contingent capital: A solution or the beginning of a new problem?

…but do expect a steep drop when a conversion occurs How do you think the market will react to a conversion?

Source: RBS Credit Strategy

Investors are searching for yield Why are you buying cocos?

Source: RBS Credit Strategy

Investors are calling for greater standardisation from regulators

Yield is the top reason why people buy cocos, despite heavy losses expected upon trigger event

0%

10%

20%

30%

40%

50%

60%

70%

80%

Yield Conversion isunlikely

Lack ofalternat ives

Cheap vs risks

0

10

20

30

40

50

60

70

0 -2 -4 -6 -8 -10 -12 -14 -16 -18 -20

Avg expected drop: -15%

% answers

But high tail risk

Coco market price drop following a conversion

31

3. A new financial world: Boosting non-bank lending

Source: The Economist

32

What will the ECB do? CE, not QE is the game changer for credit

Refi

rate cut

Forward guidance

Liquidity easing

LTROs

Negative deposit rates

QE

Credit easing (buying ABS)

Credit easing (buying bank loans)Potential game-changers

FX reduction

33

Closing the gap: New funding sources can offset loan deleveraging

Source: ECB, RBS Credit Strategy estimates

-400

-350

-300

-250

-200

-150

-100

-50

0

Decline in NFCloans since May 2012

Annual growth inHY bond market

New C LOs andsecuritisations

Fresh EIBlending

Non-banklenders

Net financinggap

€bn

-374

+50

+40

+80 -154

+50

34

4. The exit show: QE, asset bubbles and collateral effects for US and UK banks

Source: Google images

35

QE

Which asset class is already in a bubble?

1. Long-term Treasuries and Gilts 2. US high yield and leveraged loans 3. UK property 4. Periphery bonds 5. Technology stocks 6. Coco bonds 7. Bubbles, bubbles everywhere!Source: Google images, Marmite

36

“Now, back to Macro. What is your exit strategy? The players won't be in on the scam, so they'll all think it's their lucky night, but you'll never get them out of there with their winnings, they'll gamble it all back. That's Vegas and that's your problem.”

Roman Nagel, Ocean’s ThirteenSource: Google images

37

US labour markets back to (a different) normal

Source: RBS Credit Strategy, Atlanta FedSource: RBS Credit Strategy, BLS

38

Microwave risk can turn bondholders into popcorn

BoE: loosest policy in 320 years UK Bank of England Bank Rate, %

Source: RBS Credit Strategy, Bank of England

The Pruman Show: Macro-pru and microwave risk in the UK

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

1700 1750 1800 1850 1900 1950 2000

UK Bank Rate

London calling – a bubble Change in house prices since 2007

Source: RBS Credit Strategy, HM Land Registry

39

Getting out of the leverage trap will hurt UK consumers

Source: RBS Credit Strategy, ONS, Bank of England. Assuming house price to income of 4.6x for the 80% LTV mortgage and of 5.2x for the 95% LTV.

12,000

14,000

16,000

18,000

20,000

22,000

24,000

0% 1% 2% 3% 4% 5%Bank Rate

W e are hereIf Ba nk Rate goes to 4% disposable income would fall b y £5,000 (-21%)

A small 25b p rate hike 1 year from now wo uld only reduce disposable income by £320 (-1.5%)

But for borrowers with a 95% mortgage the decline is

£5,800 (-28%)

80% LTV

95% LTV

Disp osable inco me (£)

40

“The positive news is the British economy is continuing to grow and is creating jobs. And it is positive news that at a time of international instability we are a safe haven in the storm.”

-

George Osborne, Chancellor of the Exchequer, July 2011

“A healthy housing market is good for our economy and will help to support the recovery [...] But let's not be naive. Anyone with more than a passing interest in British economic history is aware that the UK housing market has a sort of microwave type quality to it, with a tendency to turn from lukewarm to scalding hot in a matter of a few economic seconds.”

-

Spencer Dale, MPC Member, April 2014

41

Source: Google images. No animals or planets (only banks) were harmed for the making of this slide

Conclusions

QE

1. Europe is on a trajectory of structural improvement to bank/credit markets

2. Banks still need more capital and will take time to lend again, despite TLTRO

3. But European policymakers are on the right path: credit easing (CE) with ABS is a real game-changer

4. The US and UK exit will be more problematic, with high popcorn risk

42

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