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European Banks in The Endgame

Kristi Rohtsalu

May 2013

Copyright © Kristi Rohtsalu 2013. All rights reserved.

The contents of this presentation are not intended as a recommendation to buy or sell any security.

Who is who in European banking?

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Regulators & authorities Banks

Central banks:

ECB, ESCB and the

Eurosystem

European System of Financial

Supervision:

European Banking Authority

(EBA) and national supervisory

authorities

European Systemic Risk Board

(ESRB) under the ECB

Top bank brands:

National banking associations

and European Banking

Federation

+9 more G-SIBs (global systemically

important banks)

Cautionary statement*

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Banking data and statistics are often not directly comparable.

* See Appendix for more info.

Apples and oranges may look similar but they are not the same.

This analogy often applies to banking stats.

European banks in international comparison

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EU-27 Euro area UK USA Japan

Size of economy

GDP (current prices, € trillion, 2011) 12.65 9.42 1.75 10.83 4.24

Population (million, 2011) 502.4 332.0 62.6 315.0 125.5

Banking

Number of banks 7 162 6 210 368 6 291 142

Total assets of banks (€ trillion) 35.9 30.4 8.1 9.8 8.3

Total bank assets, % of GDP 284% 323% 463% 90% 196%

Total assets of top 5 banks (€ trillion) 10.6 8.5 7.3 4.8 4.6

Concentration: top 5 banks’ assets as %

of total bank assets30% 28% 90% 49% 55%

Concentration: top 5 banks’ assets as %

of GDP84% 90% 417% 44% 108%

Source: European Banking Federation, International Comparison of Banking Sectors (available as of April 2013)

Consider & compare the highlighted figures:

EU & US: debt financing for households and enterprises

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In contrast to the U.S., Europe (still) has a bank-based model:

Data source: European Banking Federation, EU Banking Sector: Facts & Figures 2012

0%

20%

40%

60%

80%

100%

Europe US

Capital markets etc.

Banks

Figures in the EU represent a variety of financial systems (1/2)

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Banking systems in Europe differ by size and ownership:

Data source: ECB – Consolidated banking data (Q2 2012), and Eurostat (GDP for 2012)

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E

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EE IE

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ES

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PT SI

SK FI

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CZ

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LV LT

HU

PL

RO

SE

UK

Bank assets - foreign banks (% of GDP)

Bank assets - domestic banks (% of GDP)

Eurozone countries

Rest of EU-27

Eurozone total

Figures in the EU represent a variety of financial systems (2/2)

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In some EU countries, the share of ‘shadow banks’ in total banking

assets is bigger than in the others:

Data source: ECB – Flow of funds data (Q2 2012), and Eurostat (GDP for 2012)

Note: Due to lack of detailed data about shadow banking in Europe, a broad definition that includes all other financial institutions (excl. Eurosystem, banks, and insurance and pension funds) is used.

0% 20% 40% 60% 80% 100%

Luxembourg

Ireland

Netherlands

United Kingdom

Denmark

Belgium

Italy

Sweden

Cyprus

France

97% 96%

61% 58%

83%

25%

60%42%

204%

127% 123%

59%

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237%

174%

109% 105%91%

62%

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Germany Italy SpainSwe-den

SwitzerlandFrance

Top 20 European banks by assets, Total assets (Q2 2012) / Home country's GDP (2012)Rank indicates bank's rank in the ranking "Top Banks in Europe 2012". Number in brackets indicates asset volume in billions of euros.

Sources: BanksDaily.com, Eurostat, interim reports of banks

United KingdomNetherlands

... And Too-Big-to-Save banks...

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In several countries, banks are bigger than the economy:

The problem

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There is too much debt.

All advanced economies are at or above the limit

where debt becomes a drag on economic

growth...

Debt overhang in eurozone (EZ), in UK and in US

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Data sources: BIS, ECB, Eurostat, Federal Reserve Bank of St. Louis

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EZ Non-Financial Debt, % of GDP

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US Non-Financial Debt, % of GDP

Nothing has really improved, the debt has been transferred from one

sector to another:

The problem for bankers

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...

For each debtor there is a creditor.

A debtor’s problem is a creditor’s problem.

A debt crisis is also a credit crisis.

...

Banks’ return on equity (ROE) < cost of equity

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Average return on equity, and cost of equity (derived based on CAPM) for G-SIFIs

Source: IMF, Global Financial Stability Report: Old Risks, New Challenges (April 2013)

Red line (ROE) has been below the blue line (cost of equity) ever

since the start of the crisis in 2007:

What has to happen?

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For insight, we need to go to the edge of

economic and monetary theory...

Theoretical perspective: What has to happen?

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1. Money is debt, i.e. loan on the asset side and

deposit on the liability side of a bank’s balance

sheet.

2. For debt, borrowers have to pay interest which

has never been ‘created’ as deposit on the

liability side of a bank’s balance sheet.

3. As interests for old loans need to be paid from

new money, that is from new debt, the debt curve

is growing exponentially.

4. On the other hand, for each new dollar or euro in

debt, there is less and less economic output.

5. At a point, economic output is not enough to

support the level of debt; that’s where ‘the music

stops’.

6. Somehow we have to get back to the levels

where economic value created per dollar or euro

in debt supports the level of outstanding debts.

Unless there is a miraculous jump in the value created by the real economy,

part of the debt has to be either: a) inflated out, or b) written off:

We are around

here.

Money ‘created’ ($ or €)

De

bt

to b

e r

ep

aid

/ e

co

no

mic

va

lue

cre

ate

d (

in $

or

€)

Debt

Economic

output

0

If debt has to be reduced, you’d ask...

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... Who / which country or bank

..will be left without a chair next in the ‘game of

musical chairs’?

The question is not that easy to answer

because of the...

...‘Lethal embrace’ of banks and governments...

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Greece, ...

Ireland, ...

Governments can sink banks... ... And banks can sink

governments

... Re-inforced by rating agencies...

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– Moody’s, credit opinion on RBS Group (12 Mar 2013)

‘Over the medium-term downward pressure on the senior debt

and deposit ratings could also arise if UK, European and

international authorities made concrete progress in enabling

burden sharing with senior debt holders in the resolution of large,

complex banks...’

... With controversial statements like this (stresses added):

... And because of the...

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... Linkages between banking nationalities:

Source: BIS, CGFS Papers, No 43. The impact of sovereign credit risk on bank funding conditions (July 2011)

BE = Belgium

CH = Switzerland

DE = Germany

ES = Spain

FR = France

GB = United Kingdom

GR = Greece

IE = Ireland

IT = Italy

JP = Japan

NL = Netherlands

PT = Portugal

US = United States

Oth = other countries

Ranking of countries

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Based on...

1) Severity of the debt problem:

Debt burden of the non-financial sector (households

+ non-financial companies + public sector)

Debt concentrations

2) Capacity of the country’s financial system to absorb

losses:

Capitalisation / leverage of the banking system

Country ranking: severity of the debt problem

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Malta’s debt burden is the highest, followed by Spain and Belgium.

Data source: Kristi Rohtsalu, Europe’s Debt Hole and What It Means? (August 2012)

Debt overhang

At limit

Neutral

Public sector NF companies Households Total

1 Malta MT

2 Spain ES

3 Belgium BE

4 France FR

5 Sweden SE

6 Netherlands NL

7 Denmark DK

8 Luxembourg LU

9 Italy IT

10 United Kingdom UK

11 Finland FI

12 Austria AT

13 Germany DE

New economies

1 Slovenia SI

2 Latvia LV

3 Estonia EE

4 Lithuania LT

5 Slovakia SK

MT

ES

BEFR

SE

NL

DK

LU

IT

UK

FI

AT

DE

SI

LV

EE

LT

SK

0,0

5,0

10,0

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20,0

25,0

30,0

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Ba

nk

ing

sec

tor

leve

rag

e (

As

se

ts /

Eq

uit

y)

Non-financial debt (% of GDP)

Country ranking: debt problem & banking system’s leverage

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At the riskiest end, we find some of the countries generally perceived as

safest: Sweden, Netherlands, Denmark (besides Spain, Belgium, France

and Malta).

Data sources: ECB, Consolidated Banking Data (Q2 2012); Kristi Rohtsalu, Europe’s Debt Hole and What It

Means? (August 2012)

AT = Austria

BE = Belgium

DE = Germany

DK = Denmark

EE = Estonia

ES = Spain

FI = Finland

FR = France

IT = Italy

LT = Lithuania

LV = Latvia

LU = Luxemburg

MT = Malta

NL = Netherlands

SE = Sweden

SI = Slovenia

SK = Slovakia

UK = United Kingdom

Threshold for

debt becoming a

drag on growth.

Ranking of Europe-based large international banking groups

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Basis for ranking:

• Financial results (as at Q2 2011 and as at Q4 2012)

• Analyst conference calls

• Official sources such as: IMF, Global Financial Stability Report: Old Risks, New

Challenges (April 2013)

• News coverage

Key indicators considered:

• Business model: Loans / Total assets

• Funding structure: Loans / Deposits

• Capitalization / Solvency:

Risk-weighted assets (RWA) / Total assets

Capital, common equity tier 1 (CET1) / Total exposure

• Efficiency: Costs / Income

• Market valuation: Price-to-Book ratio

• Management opinion: Proposed dividend / Book value

Banks: What I saw in (the hot) summer of 2011

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See the article: http://blog.logicoffinance.com/2011/08/hey-europe-what-is-going-on-part-3.html

More or less, every bank has very little capital and a funding gap:

Advanced risk management contributed to bringing us here

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Basel II / Basel III formula for running a bank with very little

capital while displaying a solid regulatory capital ratio:

RWA

CCAR

CAR – capital adequacy ratio

C – capital, consists of: common equity (CET1), additional

tier 1 capital (preferred shares etc.), and tier 2 capital (sub-

ordinated loans etc.)

RWA – risk-weighted assets, consists of: credit risk RWA,

market risk RWA, and operational risk RWA

Where:

Capital ratios of large EU banks (averages)

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0%

2%

4%

6%

8%

10%

12%

14%

16%

Current Basel III CET 1 / Exposure

CET 1 / Exposure

Total Capital

Tier 1

CET1

While current average regulatory capital ratio for large EU banks is 14.7%, their common equity capital forms just 3% of their total exposure:

Data source: EBA, Basel III monitoring exercise. Results based on 30 June 2012 (March 2013)

What has happened with European G-SIBs since the hot summer

of 2011?

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Data sources: banks’ financial statements; own calculations

NB! These indicators provide only limited picture.

Not much as far as solvency is concerned:

Assets /

Home

country's

GDP

Loans /

Total

assets

RWA /

Total

assets

Core Tier

1 capital

ratio

Core Tier

1 / Total

assets

Assets /

Home

country's

GDP

Loans /

Total

assets

RWA /

Total

assets

Core Tier

1 capital

ratio

Core Tier

1 / Total

assets

DEUTSCHE BANK AG → DE 76% 21,3% 17,3% 10,2% 1,8% 76% 19,7% 16,6% 11,4% 1,9%

BANCO SANTANDER S.A. ↓ ES 115% 62,1% 47,1% 9,2% 4,3% 121% 54,9% 43,7% 10,3% 4,5%

BBVA ↓ ES 51% 60,9% 56,5% 9,0% 5,1% 61% 55,3% 51,6% 10,8% 5,6%

BNP PARIBAS → FR 103% 34,8% 30,9% 9,6% 3,0% 94% 33,1% 28,9% 11,8% 3,4%

CREDIT AGRICOLE → FR 78% 43,9% 28,5% 9,6% 2,7% 99% 36,6% 23,9% 11,4% 2,7%

SOCIETE GENERALE → FR 54% 32,5% 28,8% 9,3% 2,7% 62% 28,0% 25,9% 10,7% 2,8%

BPCE → FR 52% 53,1% 38,3% 8,5% 3,3% 57% 50,1% 33,2% 10,7% 3,6%

HSBC HOLDINGS plc → UK 105% 38,6% 35,2% 13,3% 4,7% 108% 37,1% 41,7% 12,3% 5,2%

RBS GROUP plc ↑ UK 102% 37,7% 30,0% 11,1% 3,3% 97% 38,1% 35,0% 10,3% 3,6%

BARCLAYS plc ↓ UK 100% 29,6% 26,5% 11,0% 2,9% 97% 28,6% 26,0% 10,9% 2,8%

UNICREDIT S.p.A ↓ IT 60% 61,1% 48,5% 9,1% 4,4% 59% 59,0% 46,1% 10,8% 5,0%

ING BANK NV ↑ NL 158% 57,4% 33,4% 9,4% 3,1% 139% 62,2% 33,3% 11,9% 4,0%

Nordea Bank AB (publ) ↓ SE 157% 56,0% 30,3% 11,0% 3,3% 166% 51,1% 24,8% 13,1% 3,2%

UBS ↑ CH 266% 21,4% 16,7% 16,1% 2,7% 212% 22,2% 15,3% 19,0% 2,9%

Credit Suisse → CH 208% 22,5% 20,9% 13,1% 2,7% 156% 26,2% 24,3% 15,5% 3,8%

BankHome

Country

Review in summer 2011 Review based on Q4 2012 data

How the financial collapse has been avoided so far?

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1. Central banks are providing commercial banks with cheap

money.

2. Banks can then use this cheap money to acquire risky assets

that earn higher returns than the cost of funding.

3. Via various often complex arrangements, central banks then

more or less assure that the risky assets will not lose in

value, or at least not too much.

4. Accounting rules enable banks to take losses from the so-

called legacy portfolios only gradually, so that losses can be

offset from the future (subsidized) returns.

The reality and what’s coming

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• National ring-fencing and prisoner’s dilemma

• Banks are fighting for life and death

• A number of the Europe-based G-SIBs are due to be

reduced to regional or local players and/or sold in parts

• A significant part of the financial system is still due to be

nationalized, but not feasible on country level

• Bank creditors are set to take losses

• Financial center countries need to reconsider their business

models, incl.

− Luxemburg, Malta, Liechtenstein and Switzerland in

addition to Ireland and Cyprus

• Not much is needed for things to go bad

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Thank you!

Kristi Rohtsalu

LinkedIn: http://www.linkedin.com/in/kristirohtsalu

Contact: krohts@gmail.com

Disclosures and disclaimers

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KRISTI ROHTSALU’S DISCLOSURE:

I’m not qualified to give any specific investment advice. I’m not a CFA Character holder (Chartered Financial Analyst), a CFP

(Certified Financial Planner), a ChFC (Chartered Financial Consultant), a CMT (Chartered Market Technician), or the holder of

any other title from the “alphabet soup” of finance professionals. I’m long in some of the stocks mentioned (RBS, UBS, CS) –

however, this is for other reasons than profiting from my investments.

DISCLAIMER:

It’s not an offering for any investment. It represents only the opinions of Kristi Rohtsalu. Any views expressed are provided for

information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not

in any way a testimony of, or associated with, Kristi Rohtsalu or Finlighter OÜ. Kristi Rohtsalu is the founder of Finlighter OÜ.

This report may contain information that is confidential or privileged and does not constitute an offer for or advice about any

alternative investment product. Past performance is not indicative of future performance. Investors should discuss any investment

with their personal investment counsel or do their own research.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed here may change

without prior notice.

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Appendix

Precaution: Lies, damned lies, and statistics

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Even though you are seeing stats and comparisons, please be aware that

data may not actually be comparable:

• Banks are applying different accounting standards, importantly when it comes to practices of (not)

consolidating off-balance sheet vehicles

E.g.: JP Morgan Chase & Co., Bank of America Corp. and Wells Fargo & Co. would double in assets if

they applied international standards (according to Thomas Hoenig, vice chairman of FDIC, based on Q3

2012 data)

• Banks have different definitions of non-performing loans and doubtful assets, as well as different

provisioning rules (an issue among others highlighted by the ECB when compiling aggregated bank stats

for the EU)

• Banks’ internal valuations of assets and liabilities may not be comparable, and certain assets are

valued purely based on internal models (an issue among others highlighted by the IMF staff when

conducting the financial stability review of the European banks)

• Risk parameters and risk-weighted assets differ bank-by-bank more than justified by differing risk

profiles (among others highlighted by the EBA when presenting the results of the EU bank stress test

2011)

• Differences in aggregated country-level stats (sample, definitions, etc.)