Markets & Finance

Europe's Big Banks: An S&P Report Card

From Standard & Poor's RatingsDirect

Despite early signs of a less benign environment, the major banks in Western Europe are still poised to report strengthening performance in the first half of 2006, and continue to show positive ratings momentum. The structural improvements that have been seen over the past few years are likely to partly offset the expected cyclical softening in certain markets, and should provide an underpinning for overall performance to be at levels consistent with ratings.

Key trends that have supported recent positive rating actions are the growing diversity of revenue streams, increased focus on operational efficiency, improved ability to manage more effectively across business lines and borders, and risk management processes that, while not providing total insulation, should help the industry absorb cyclical swings. These strong fundamentals are still key drivers of positive outlooks for some banks; and ratings are expected to continue to move upward on a selective basis in the second half of 2006 as they have done in the second quarter, assuming that the banks demonstrate relative resilience in the face of less favorable market conditions.

Most banks demonstrated strong performance in the first quarter of 2006, with all indications still of increased profitability in the second quarter of 2006, despite the onset of market turbulence toward the end of the period. As in 2005, strong income growth, well-controlled costs, and generally improving bad debts combined to produce strong increases in pretax profits.

NORMALIZATION TREND. The big question is whether the recent turn in the financial markets signals the end of the benign period that has underpinned bank profit growth. Banks with relatively large exposures to capital markets are likely to demonstrate slower earnings growth going forward, but the momentum created by strong performance for most of the first half of the year, and the benefits accruing from business diversification, should help maintain good outcomes for the group as a whole for 2006. Some banks with larger exposures to capital markets could report moderately lower earnings in 2007, however, if less favorable market conditions persist.

Standard & Poor's still expects an eventual "normalization" of corporate credit quality (although this is not yet evident at banks) and recognizes that more difficult capital market conditions will inevitably restrain profit growth. Rising interest rates in the Eurozone could also slow lending growth and affect asset quality (although they will also improve interest margins at some banks). The positive structural trends within the banking sector should help offset some of these cyclical features, however.

Barring marked and prolonged downturns across a range of business classes, which would give rise to higher than expected increases in risk charges and a severe slowdown in earnings, bank ratings should exhibit little downward pressure. Current ratings incorporate an expectation that profit growth will decline to more normal levels (and possibly show moderate declines at some banks that have recently reported exceptionally high profits) as certain market-related earnings slow and as credit charges increase cyclically.

Here is S&P Ratings Services' review of the outlook for select major Western European banks:

ABN Amro Bank N.V. (AA-/Stable)

The stable outlook reflects S&P's expectation that ABN AMRO's (ABN) earnings will continue to benefit from efficiency improvements generated by the group shared services initiative. The success of the downsized and further integrated wholesale clients business will be key in determining future performance, as will the strengthening of non-mortgage-related revenues for the U.S. business. A measured process of acquisitions that maintains the bank's current financial profile—such as the recent acquisition of Banca Antonveneta—will not affect the ratings. On the contrary, a more aggressive acquisition strategy, particularly in emerging markets, which would add execution and financial risks to the balance sheet and leverage its capital position, would probably have negative rating implications.

Banco Bilbao Vizcaya Argentaria (AA-/Stable)

The stable outlook reflects S&P's expectation that BBVA (BBV) will maintain its strong operating performance, particularly in Spain and Mexico. Moreover, we expect BBVA to maintain its core capital objective of 6%. The outlook takes into account BBVA's willingness to continue to conservatively manage its exposure to Latin America. We expect the bank to be able to withstand a meltdown in one of the small Latin American markets, should this occur. A severe stress in Mexico, while unexpected, would, however, have negative rating implications. S&P's base case is one of stable ratings for BBVA. An upgrade would depend on BBVA showing a more balanced business profile with lower reliance on emerging markets, while obtaining a solid financial performance in all its business lines.

Barclays Bank (AA/Stable)

The stable outlook reflects the expectation that earnings will remain good overall. Arrears on U.K. personal sector lending are rising but should remain manageable. Barclays (BCS) has an interest in value-creating corporate activity, however, and in organic expansion. S&P will continue to monitor the effect of this strategy on earnings quality, capitalization, and the risk profile, as it could in some circumstances put pressure on the outlook. A positive rating action would require continued improvements in the diversity and sustainability of Barclays' earnings as well as clarity regarding the changing international profile. However, tight capital policy will likely restrain the ratings. A negative rating action could follow if risk charges jump dramatically or if the balance sheet is leveraged excessively to finance an acquisition.

BNP Paribas (AA/Stable)

The stable outlook reflects our expectation that BNP Paribas will maintain its robust financial profile and preserve its credit-risk-averse culture, despite a likely moderate rise in loan-loss provisions from their cyclical, unsustainable lows in 2004 and 2005. The outlook also factors in our belief that the expansion policy of the group will not significantly hurt its risk profile or further weaken its capital position. Although the proposed BNL acquisition entails some execution risks, we expect BNP Paribas to manage the integration process well, in line with the group's successful track record. We could revise the outlook to negative if these expectations are not met. Conversely, we could revise it to positive if the group further diversifies its businesses and earnings without damaging its risk profile or capital position. This would particularly hinge on BNP Paribas' ability to demonstrate that BNL's integration is proceeding as planned.

Commerzbank AG; Eurohypo AG (A-/Stable)

The stable outlook on Commerzbank is based on S&P's expectation of reduced earnings volatility for Commerzbank and that Eurohypo's profitability will continue to benefit from asset shifts to higher margin business and acceptable provisioning needs. The purchase price and funding of the acquisition of Eurohypo was in line with the group's plan. S&P expects that capital will be gradually replenished over the next two years. For S&P to consider an upgrade, the new group would have to demonstrate stronger core earnings momentum to catch up with higher-rated international peers. This would be helped by an improvement in the domestic economic and competitive environment and still-fragile real estate markets, which is as yet uncertain. Conversely, a deterioration of asset quality and earnings could have negative rating implications.

Credit Suisse Group; Credit Suisse (A+/Stable; AA-/Stable)

The stable outlook on CSG reflects its major and sustained improvement in profitability, which has led to a material increase in capitalization, which S&P expects will improve further on the sale of Winterthur. The outlook also reflects some potential for franchise development through the integration of its banking businesses, which should lead to greater coordination and cross-selling over the medium term. A positive change in the ratings would be subject to a further major improvement in the profitability of the group, particularly in the investment bank, which must show sustained structural improvement, coupled with a stable risk profile and continued strong performance in the private bank and asset management divisions. Conversely, negative ratings implications could arise from unexpectedly large market losses, litigation charges, or a failure to deliver results from the integration of its banking businesses.

Deutsche Bank (AA-/Stable)

The stable outlook reflects S&P's expectation that Deutsche Bank (DB) should be able to maintain sound earnings in a less favorable capital-market environment given the diversification achieved within Corporate Banking & Securities and the enhanced absolute bottom-line contribution from its other business lines. Management is expected to remain committed to further progress in businesses outside investment banking. Significant and sustainable progress in delivering continued profitable growth across business lines—but most importantly in the non-investment-banking divisions—would have positive rating implications. A failure to demonstrate the sustainability of sound earnings, particularly in its investment-banking division, would be considered negative. A significant increase in leverage would also have negative rating implications. Deutsche Bank is increasingly eager to grow retail operations in emerging markets. If the bank were to embark on a major acquisition, such a transaction would have to be assessed in light of the impact on its financial profile, the strategic fit, and Deutsche Bank's track record in the respective markets.

HSBC Holdings PLC; HSBC Bank PLC (AA-/Stable; AA/Stable)

S&P expects HSBC (HBC) to underpin its solid profitability and mitigate the risk of economic stress through its very strong geographic and earnings diversification and its continuing organic earnings growth. S&P does not expect HSBC to compromise its strong liquidity, healthy capitalization, and sound risk-management principles to chase growth, or to make transformational acquisitions. HSBC Finance's earnings are expected to show better underlying quality going forward, helped by increasing integration into the group. A negative rating action could occur if the group exhibits structural declines in earnings quality or grows rapidly through additional acquisitions in volatile business classes, if risk charges jump dramatically, or if the risk profiles of the emerging market operations deteriorate significantly. A positive rating action would require continued control of risk charges and enhanced franchise development in markets where HSBC is not a top-tier player.

ING Bank N.V. (AA/Stable)

The stable outlook reflects S&P's expectation that ING Bank will sustain the tangible progress achieved in recent years. Although the pace of recent earnings growth will be very difficult to maintain, ING Direct should drive further improvements in profitability. The expansion of retail banking, refocusing of wholesale activities, and implementation of more proactive risk management will continue to benefit the bank's overall risk profile. As a core member of the ING Group (ING), future rating actions on ING Bank would most probably be driven by developments across the group rather than purely within the bank. Rating changes are not considered likely but could result from a material positive or negative shift in the group's profitability or capitalization/leverage.

Royal Bank of Scotland Group PLC (The); National Westminster Bank PLC; Royal Bank of Scotland PLC (The) (AA-/Stable; AA/Stable; AA/Stable)

S&P expects that efficiency and overall asset quality will remain good (despite the upturn in U.K. personal sector arrears) and that retained earnings generation will remain strong. Margin declines in some businesses should be easily offset by income growth across the group. S&P expects RBSG to pace its buybacks in line with profit generation to ensure that capitalization remains stable compared with yearend 2005 levels. The outlook could be revised to negative if core capital is not maintained in line with expectations, whether because of weaker-than-expected earnings generation or additional acquisitions (no material acquisitions are expected, however). S&P will also continue to monitor the financing and structuring of ongoing expansion and its impact on risk and earnings. A positive ratings action would require continued delivery of superior profitability. RBSG's high leverage is likely to restrain the rating, however.

Societe Generale (AA-/Positive)

The positive outlook reflects the potential for an upgrade if SocGen can sustain the stronger operating profitability posted in 2004 and 2005 while maintaining its strong balance sheet and focused strategy. This would require the expansion of the bank's growth platforms to compensate for any pressures on domestic retail revenues. We also expect in 2006 a moderate increase in the cost of risk; continued small to midsize acquisitions in retail businesses outside France; and a Tier 1 ratio of 7% to 7.5%, depending of the risk profile of the acquisitions. The outlook could be revised back to stable, however, if these expectations are not met.

UBS AG (AA+/Stable)

The stable outlook reflects S&P's expectation that UBS's (UBS) performance will remain strong, although the powerful revenue growth achieved in the supportive environment of recent years will be hard to match. Even if markets become less favorable for a prolonged period, the strength and diversity of UBS's main business lines are expected to sustain a robust level of earnings. Close management of lending underpins UBS's credit risk profile, and a probable increase in value-at-risk (VaR) is expected to be closely controlled and relatively modest in the context of group resources. Core capitalization is expected to remain robust. A deterioration in the stability and sustainability of earnings, or a significant increase in UBS's risk appetite or leverage, could have negative rating implications. A positive rating action is unlikely given the sensitivity of revenues to financial market conditions.

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