The US earnings publications season has once again demonstrated that US companies in general and financials in particular are in good health. Since the beginning of the year, the shares of JP Morgan, Bank of America and Citigroup have risen by 20%, 23% and 35%, respectively. Only Wells Fargo has lagged behind, with a return on investment of just 6%. The combined market capitalization of these four big banks is now more than $1 trillion. In the eurozone, the four largest banks represent less than a quarter of that amount! JP Morgan’s earnings have totaled $31 billion over the last 12 months; this is more than the market capitalization of Société Générale.

 

While the size of BNP Paribas’ balance sheet is very close to that of the big US banks, its market capitalization is between 1/3 and 1/6 of theirs. So it’s not a problem of balance sheet size, but of the profitability of banking activities. Neither cross-border mergers nor the creation of national champions is likely to be the solution, especially as the size of certain balance sheets is already very high compared with national GNPs, which could increase systemic risk. 

 

European banks are lagging behind their US counterparts in part because of the difference in growth rates between the two geographic regions. The US economy is projected to grow at 2.4% in 2019 and 1.9% in 2020, vs. 1.1% and 1.4%, respectively, in the eurozone. But the difference is also due to exogenous factors that have become virtually structural. Since the election of Donald Trump, the US administration has adopted looser tax and regulatory policies. This is giving US banks undeniable competitive advantages. At the same time, in Europe, the regulatory vice has not been loosened, and the negative interest rate policy has created an additional de facto tax on banks. As a result, since November 1, 2016, the MSCI US banking index has advanced by 51.5%, vs. 45% for the S&P 500, while the MSCI Europe banking index has risen only 13%, vs. 25% for the Stoxx 600.

 

This situation is all the more prejudicial in that the banking sector will face a multitude of challenges owing to the major technological changes that blockchain and artificial intelligence will bring with them. For the moment, the Payment Services Directive 2 (PSD2), which came into effect in January, has had only a limited impact, but this is likely to intensify beginning in September, when the parts of the directive requiring strong customer authentication and third-party access to account information (with the account owner’s approval) come into effect.

 

While the equity markets have integrated this outlook, by assigning very differentiated valuations, the same cannot be said of the credit markets. For the moment, the latter see only the problem of profitability. As such, five-year senior CDSs on European banks are trading at levels very similar to those of their US counterparts. This does not seem to reflect the situation the sector will face. In addition, the five-year Senior Fin Markit iTraxx CDS index has fallen from 110 bps at the beginning of the year to 68 bps.

 

The valuations of more junior issues are even more stretched, in particular AT1s. Some of them are now offering a yield-to-call that is less than the dividend yield of the equivalent equity. Performance since the beginning of the year has been very high, and current valuations certainly represent an opportunity to take profits. We say this for two reasons: firstly, Italian systemic risk has not gone away (five-year Italian CDSs are trading at 188 basis points); secondly, there is still idiosyncratic risk, with Deutsche Bank still a source of concern (five-year senior DB CDSs are trading at 160 basis points).

 

Conversely, for investors who want to play improvement in the European financial sector, equities would seem to be a more judicious investment vehicle than credit, on a risk-adjusted basis. The drivers of this improvement could be looser regulation, lower sovereign risk or an adjustment to the negative interest rate policy.