European Banks Strategy
Inflation: what does it do to
banks?
Matt Spick
Research Analyst
(44) 20 754 57895
matt.spick@db.com
Where are we in the banking cycle?
We view European banks as beginning a de-leveraging process, as they enter the
downturn phase of the cycle. The critical question for banks over the next one to
two years will be the depth of this downturn, and the severity of the credit cycle.
We look at both of these issues in this report.
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DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1
Industry Analysis
Top picks
Credit Suisse Group (CSGN.VX),CHF57.15 Buy
Barclays (BARC.L),GBP392.00 Buy
BNP Paribas (BNPP.PA),EUR68.82 Buy
Societe Generale (SOGN.PA),EUR67.77 Buy
DnB NOR (DNBNOR.OL),NOK75.70 Buy
EU Banks vs FTSEU300, Since 2003
80
90
100
110
120
130
140
May-03 Nov-03 May-04 Nov-04 May-05 Nov-05 May-06 Nov-06 May-07 Nov-07 May-08
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Inflation is the key: if it picks up…
We see a real risk that global inflation will continue to rise, especially if emerging
market growth stays strong and the US slowdown is shallow. History tells us that
higher inflation tends to drive lower leverage and a smaller banking sector relative
to GDP. Inflation as such does not drive lower nominal RoEs (in practise inflation
transfers value from savers to borrowers, eroding the value of debt), but real
returns on equity tend to decline as inflation increases, even turning negative, and
hence reducing the ratings of the sector as returns fail to match the rising cost of
capital. In the first part of this report we review the implications of higher inflation
for banks, but we also believe there will be a (belated) policy response of sharply
higher interest rates, to drive inflation out of the system.
…and the banks will suffer from the policy response
In the second part of this report we review the consequences of higher interest
rates to fight inflation. We expect this to add to the de-leveraging process already
underway. We also expect higher rates combined with weaker growth to drive a
move to peak credit losses, which we estimate could reduce bank earnings by a
further 27%, on top of the 22% downgrades to European banks forward earnings
we have already seen over the last twelve months. Overall, we see inflation as
potentially the single biggest issue facing the sector.
Valuation and top picks
Our sector stance is that we are concerned about risks from inflation, and
therefore our top picks fall into two categories. The first is banks that we see as
defensive in a downturn, resilient in a de-leveraging environment, as well as cheap
on fundamentals. In this category we include BNP Paribas (Buy, target price
Euro 85), Société Générale (Buy, target price Euro 88), and we once again add
DnB NOR (Buy, target price NOK 85). We also see a (much smaller) second group
of stocks where we see risk management as much better than the market
realizes, and where valuations are markedly too low. In this category is
Credit Suisse (Buy, target price CHF 68), and we add Barclays (Buy, target price
GBP 6.00). As stated above we see the key risks to the sector, even for our top
picks, are higher inflation and the potential for a sharp increase in interest rates
and increased drive to de-leverage. For all banks in our universe, we believe that
such a scenario would lead to absolute earnings and share price falls.

Table of Contents
Key points and top picks................................................................... 4
Key points ................................................................................................................................4
Top picks..................................................................................................................................4
Where are we in the cycle?............................................................... 5
Entering the downturn: 20% to 30% more downgrades to come?..........................................5
Valuations: unattractive if we experience further downgrades .................................................5
Banks no longer look cheap versus the rest of the market .......................................................7
Inflation: is it a threat? ...................................................................... 8
What is happening to global inflation? ......................................................................................8
Inflation: why is it a threat to banks?.........................................................................................9
Inflation: the policy response ......................................................... 13
The policy response to inflation: short-term pain for banks ....................................................13
Calculating normalised and peak loan losses: bank-by-bank ...................................................14
Investment conclusions: the inflation and credit risk scenario ................................................17
Worked example: UBS normalised credit losses ....................................................................22
Credit and valuation data ............................................................... 24
Contents ................................................................................................................................24

Key points and top picks
Key points
􀂄 European banks are entering the downturn phase of the cycle. How severe will it be?
We think that inflation holds the answer.
􀂄 While inflation in and of itself does not hurt banks as much as deflation (which reduces
collateral values and investment), it does create problems. A higher inflation environment
tends to lead to a smaller banking sector relative to GDP, and also a de-rating of banks,
as RoEs actually increase slightly in an inflationary environment, but less quickly than the
cost of capital.
􀂄 We think that the more likely outcome, however, is that a pick-up in inflation will trigger a
policy response of higher interest rates. In this report we take a detailed look at the
implications of sharp increases in interest rates and tighter monetary policy. So far we
have seen defaults rise and monetary conditions tighten because banks are seeking to
de-leverage. A sharply tighter monetary policy to fight resurgent inflation in 2009 / 2010
would drive European banks loan losses markedly higher, we believe.
􀂄 This is also important for valuation. At present European banks are trading on 8.8x 2009E
adjusted EPS, following a 15% fall YTD. This 15% fall can be broken down into a 14%
downgrade to earnings, and a 1% de-rating. But we calculate that recessionary levels of
credit losses would knock at least a further 27% off earnings across the sector. Whilst
banks might not de-rate under this scenario, they would not in our view re-rate either, so
creating substantial downside risks to share prices.
􀂄 This would reduce sector Returns on Tangible Equity to 13-14%, and at 9x earnings, 1.3x
price to tangible book. This would be our sector target price on resurgent inflation and a
tight monetary policy response, and compares with 1.8x P/TBV currently.
Top picks
Our sector stance is that we are concerned about risks from inflation, and therefore our top
picks fall into two categories. The first is banks that we see as defensive in a downturn,
resilient in a de leveraging environment, as well as cheap on fundamentals. In this category
we include BNP Paribas (Buy, target price Euro 85), Société Générale (Buy, target price
Euro 88), and we once again add DnB NOR (Buy, target price NOK 85). We also see a (much
smaller) second group of stocks where we see risk management as much better than the
market realizes, and where valuations are markedly too low. In this category is Credit Suisse
(Buy, target price CHF 68), and we add Barclays (Buy, target price GBP 6.00). As stated
above we see the key risks to the sector, even for our top picks, are higher inflation and the
potential for a sharp increase in interest rates and increased drive to de leverage. Such a
scenario would lead to absolute earnings and share price falls for all banks, in our view.