Banking sector attractive despite increased regulation

UBS study examines how higher capital requirements affect European bank stock prices. Despite lack of visibility, Swiss bank maintains positive view on sector

Routinely, bank equity studies analyze other companies, but it is rarer when a bank evaluates other banks, essentially its competitors. When a large bank evaluates the impact of regulation on the stock prices of other large banks, it can add a bit of intrigue.

Last week, UBS’s Global Research and Evidence Lab examined how “Basel 4” (an informal term for the capital requirements adopted under Basel III in 2017 but not yet fully implemented at the national level) will affect European banks.

Higher capital requirements should be feasible

UBS analysts noted in their nearly 40-page report, “The Bankroll #5,” that banking stocks have performed well in the wake of the Covid-19 pandemic, driven by rising earnings and improved payout ratios. As central bank interest rates have fallen, the earnings cycle is maturing; equity returns and potential price-earnings revaluation are increasingly key drivers of UBS’s positive view of the banking sector.

According to UBS, even with Basel 4, banks should be able to consistently deliver dividends of 10 percent, which is “extremely attractive on both an absolute and relative basis.” The good news is that higher capital requirements are manageable because sufficient equity capital can be built organically. The bad news is that Basel 4 does not mean the end of regulatory change.

European Banking Supervision as a “Disruptive Agent”

Regulators are currently reviewing the methods banks use to calculate risk-weighted assets. UBS points to 140 “actions” pending with the European Banking Authority (EBA), 50 of which are technical regulatory standards at the same legal level as Basel, to be implemented between 2025 and 2028.

“There is almost no information from lenders about the scope and timeline of what these standards might include. At present, we can only qualitatively emphasize that this will likely lead to increased regulatory capital for EBA-regulated institutions,” UBS notes.

Earnings power and free cash flow in focus

However, these concerns are not enough for UBS to revise its positive view of the banking sector. In terms of risk and visibility of potential capital returns, the Swiss bank cites Italian institutions Unicredit, Mediobanca and Intesa Sanpaolo, as well as Danske Bank, Allied Irish Banks and HSBC as positive examples.

They combine particularly high returns with strong free cash flow generation and/or have excess projected capital positions. Banks such as ING and Caixabank stand out for their payout strength, while others such as Bawag show high levels of free cash flow.

UBS itself is currently facing tighter capital requirements. The Swiss Federal Department of Finance, Finma and the Swiss National Bank jointly insist, based on the experience of Credit Suisse, that the parent company better capitalizes foreign subsidiaries in the interests of systemic stability. Those interested in how this might affect the UBS share price will have to wait for research from other banks.