European Banks Strategy
Credit losses in 2009, and
possible escape routes
Matt Spick
Research Analyst
(44) 20 754-57895
matt.spick@db.com
2009: bank performance to be dominated by credit risk
In 2008 banking sector balance sheets dominated the headlines, with banks facing
funding or capital shortfalls underperforming sharply, and the outperformers being
those banks that avoided pitfalls. We expect a similar phenomenon in 2009, with
credit risk dominating performance. We expect the worst performers to be those
that suffer capital or earnings damage from their credit portfolios, and the
outperformers to be those few that avoid the worst of the loan losses.
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LOCATED IN APPENDIX 1.
Industry Update
Top picks
UBS (UBSN.VX),CHF14.84 Buy
Societe Generale (SOGN.PA),EUR36.00 Buy
FTSE300 Banks vs Market
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Related recent research Date
The funding crunch: still no liquidity
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Will the banks manage a painful, but orderly work-out?
One piece of good news in the sector is that the liquidity situation is improving.
Banks are still growing loans too quickly, in our view, and we expect growth to
decelerate further. But the advent of government-guaranteed debt issuance over
the last few weeks of Q4 has re-opened the debt markets for banks, allowing
issuance to return to pre-September levels. Whilst this does not eliminate the
problem (the debt is still there), the funding strain has shifted from bank balance
sheets to government (and by extension taxpayer) balance sheets.
But credit losses still look to be an overwhelming problem
Even if the liquidity problems are being transferred from banks to governments,
we still see major earnings risks. In this report we focus on potential loan losses,
updating the analysis of our 5 September report. We now think that bad debt
charges could approach 3x normalised, or 210bp. We calculate that this would
drive a further 85% downgrade to sector earnings on average, and leave more
than one in three banks in loss-making territory. We also see potential losses plus
pro-cyclicality of capital charges in corporate loan books as putting capital ratios at
further risk at some banks, especially RBS, HSBC, Commerzbank and Erste Bank.
Is inflation a possible escape route?
Although the strain of funding the world’s debt is shifting from commercial banks
to governments and central banks, the debt is still there. In the end, we suspect
that moving the debt around will not provide a long-run solution, which increases
the likelihood that the policy makers could resort to inflation to reduce the real
value of debt. Whilst this could just create a new crisis in the future, inflation is
good for borrowers in the short run, and by extension the banks. This could be an
alternative escape route (and a possible source of bank outperformance versus the
wider market), albeit this looks more likely to us in the US than in Europe.
Top-down price objective for the sector of 0.5x price to tangible book value
We think that the banks will remain in the downcycle until either the debt
mountain has been written down or policy makers can inject sufficient inflation
into the system to bring the debt overhang down to an acceptable level. We see
little chance of this in 2009. We also see further earnings risk and / or capital risk at
Lloyds TSB, RBS, HSBC, Commerzbank and Erste Bank, and these represent the
key large-capitalisation banks on which we would be particularly cautious. We
have very few top picks, reflecting our negative outlook. But the improvement in
bank funding gives us some optimism that some banks will be able to outperform.
Our top picks are UBS and Société Générale.

Table of Contents
Cyclical downturn still ahead ........................................................... 4
Key points ................................................................................................................................4
Stocks where we’re cautious and top picks .............................................................................5
Into the down-cycle: Valuation..................................................................................................5
When will the cycle turn? ................................................................. 8
Key points ................................................................................................................................8
Bringing funding back into balance ...........................................................................................8
Forecasts capturing a full credit cycle.....................................................................................11
The credit cycle: updated ............................................................... 12
Key points ...............................................................................................................................12
Expectations deteriorate: financing getting worse..................................................................12
Why a three-times normalised loss rate?................................................................................16
Applying our new assumptions to the banks..........................................................................22
And finally, are we going too far? ...........................................................................................27
Methodology..........................................................................................................................28
Inflation: long-term pain ................................................................. 29
A worrying policy response? Short-term gain for long-run pain ..............................................29
What happens to banks in an inflationary environment?.........................................................29
In conclusion: a tempting solution? ........................................................................................31
Credit and capital risk ..................................................................... 33
Key points ...............................................................................................................................33
A short sensitivity analysis ......................................................................................................33
Five banks that might still be at risk ........................................................................................34
Valuation .......................................................................................... 36
Summary of exhibits ...............................................................................................................36
Valuation approach and risks...................................................................................................36