Banks’ fundamentals are the strongest in a decade. CET1 ratios are almost at their all-time high, profitability is on the rise and return on equity is finally above cost of equity. Despite all this, investors still benefit from significant spread pick up on financial bonds, and especially AT1s. In this context, What should we expect for bank credit in 2024?
Fundamentals: it’s all about rates?
Banks can be confusing. Early in 2023, most investors had finally understood that higher rates meant higher profitability. So, high rates = good. The European banks index had rallied by close to 50% from the post Ukraine war lows.
Regulations: the big sleep?
After years of watershed changes in banking regulations, it is finally time for stabilization. If banks’ capital requirements are still going up (and protecting creditors even more) it is mostly due to the phasing-in of old regulations, in particular the gradual implementation of countercyclical buffers in the EU – still an ongoing process as the map below shows. After years of debates and negotiations, the most significant piece of bank regulations, Basel 4, has now turned into an irrelevant tweak to banks’ capital requirements, mostly because banks have already adapted to the new rules.
Legacy bonds – stuck in the past
When Basel 3 introduced the grandfathering period of bank capital and implicitly created the Legacy market, a deadline was set at the end of 2021. We are now in 2024 and that market still offers interesting opportunities. How come?
Ratings: a one-way street?
Since the Covid shock, it looks like credit agencies have moved overwhelmingly in the good direction for financials. The chart below shows the average, for the three main agencies, of the logarithm of the upgrade / downgrade ratio every year. The trend of the post crisis reform was clearly interrupted by Covid but has now resumed.
Valuations: right in the middle
Despite a very tumultuous year, spread have (modestly) tightened in 2023 for all financials asset classes, except insurance RT1 bonds.
Where are the risks
2023 saw unprecedented upgrades in European bank’s earnings prospects and significant upgrades in the US, and yet we had the first failure of a GSIB and five failures in the US, with the first FDIC interventions since 2020 and the highest annual total assets of failed banks. This clearly shows that problems can happen in a positive environment.
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