European Wholesale Banks
SECTOR REVIEW
FICC trading profits – stronger for longer?
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This month we focus once more on FICC trading profits, and conclude
that there is potentially another good quarter to come—but that’s the
only good news. While there is, in our opinion, no chance of matching the
record-breaking performance seen in many banks in FICC in Q1, the sharp
increases in bid/ask spreads and healthy volumes (albeit lower than in Q1)
should mean that the qoq fall in Q2 will be less than we had previously
expected (around 25%), and the yoy comparisons will still be strong. The
prospects for inventory gains also look good.
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The global fee pool is still down 30% yoy. High-grade debt issuance
levels have begun to subside, while high-yield tracks more or less in line with
Q1 09. M&A and loan products are still 35–40% down on the same period
last year. The general picture would have been even worse were it not for a
very strong showing in April from equity capital markets, driven by a small
number of very large secondary issues. As the banking sector begins to
raise capital (particularly US institutions raising equity to repay TARP capital),
we should expect ECM revenues to continue to be strong for Q2, but there is
no real sign of a sustainable recovery in the underlying business model.
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European sector valuations look stretched. After strong share price
performances in April, most European wholesale banks are now trading at a
premium to book value. The market is implicitly suggesting that the European
wholesale banking industry is capable of systematically earning more than its
cost of equity. This seems somewhat premature to us, given that the only real
underlying good news we have had about the industry relates to largely
unsustainable trading profits rather than recurring revenues. We would note
that new capital and liquidity requirements are forthcoming during the second
half of 2009E, and that these are likely to have more impact on RoE for the
wholesale banks (which have largely transaction-driven revenue models
where revenues are a function of capital turnover) than for commercial banks
(which are more able to manage margins on the asset side).
Stronger, for longer?
As we noted in the March European Wholesale Monthly (A false dawn, 11 March 2009)
and—regarding Deutsche Bank specifically, in Making the mathematics work? (11 March
2009) and How big was the bounce? (29 April 2009)—the Q1 profits of the European
wholesale banking sector have been boosted by exceptionally strong trading profits in
fixed income, commodities and currencies. Over the Q1 conference call season, there has
been a general consensus that these revenues did not reflect a run rate for the year, but
opinions have differed on the extent to which Q1 09 could be considered genuinely
exceptional. This month, we set out the key drivers of Q1 trading revenues and begin to
analyse whether Q2 might also contain a degree of supernormal profitability that is not yet
included in forecasts. There are several issues to address, because Q1 09 saw a more or
less unique confluence of favourable factors:
Basis risk bounceback
Having widened to historically unprecedented levels in Q4 08, the cash/CDS basis
narrowed sharply over the course of Q1 09. This was extremely important for the large
trading banks, which typically held books with a considerable amount of cash securities,
credit-hedged by buying CDS protection. The explosion of this basis relationship caused
large losses in Q4 08, and while significant amounts of the big banks’ trading books were
liquidated during that quarter, the remaining positions would have benefited from a
normalisation of the basis.
At its Q1 results presentation, Credit Suisse estimated “market rebound revenues” at
SFr1.1bn in fixed income business lines, making up 20% of total fixed income revenues
(excluding ’exit businesses’). On the earnings call, Deutsche Bank denied that there were
material ‘writebacks’ of loss-making positions in Q1 09, but given that the bank has been
such a heavy user of credit mitigation and that the management of basis risk rather than
outright asset risk has been such a key part of its strategy for the past five years, it seems
clear to us that the overall book must have been exposed to the large movements in CDS
basis.