Preview EBA stress test

European Banks have underperformed the market by c.10% post UK’s Leave vote, and, trading at 0.77x TBV for 2016E (c.7.5% ROTE), a shallow recession is already priced in.

The next event is the EBA stress test on 29 July, and in isolation we argue this could be a positive outcome. That said, we see event risk ahead. MPS results are due 29 July, and it is unlikely a final solution (recap or divesting NPLs) will be in place by then, leaving the market with an unresolved issue. In the case of a solution, a positive scenario is if Atlante buys NPLs above market price. A negative scenario is burden sharing and/or an industry-paid rescue fund. Although we believe politicians ultimately want to avoid destabilising the market, a policy mistake is a risk.

EBA Stress test – screening for outliers. To gauge the outcome of EBA’s stress test, we have run banks through a model, which resembles the EBA exercise, covering 27 EU banks (just under 50% of sector by total assets). We estimate total CET1 consumption to 164bp in the adverse scenario (CET 1 off 260bp in the 2014 test), but well above our Brexit ‘shallow recession’ impact of c.50bp. We note, banks should do better as 1) capital is better (CET1 up by at least c.150bp1, since 2013) 2) ESRB scenario is somewhat milder (e.g., only 20bp this time vs. avg. 80bp funding cost shock in 2014). Unlike the 2014 test, there is no pass/fail hurdle, but we argue regulators could increase Pillar2 buffers (guidance only) if a bank is too far from its SREP ratio in the adverse scenario (with implications for banks’ capital targets, dividend policies and/or growth ambitions). Investors will screen for outliers; names with high NPL levels, small mgmt. buffer to SREP and/or material litigation costs since 2011 are sensitive: We see that UCG (N) and DB (N) could be c.100bp (or more) below their adj. SREP ratio, in the stress test. Mandatory forecast of conduct/operational risk costs is new vs. 2014 test and is a source of downside risk to our numbers.

Remain selective. To invest in banks ahead of EBA stress test/Italian recap exercise, investors must take an optimistic view of ‘no policy mistakes.’ We continue to favour names with (i) strong capital supporting dividends, despite any SREP ratio adjustments; (ii) non-EU exposure/dollar earners; and (iii) exposure to Fees to mitigate negative rates. Danske (OP, TP DKK203) and Intesa (OP, EUR2.5) are attractive 10%-plus yield stories. Bankia (OP, TP EUR0.85), Erste (OP, TP EUR30.0) and NDA (OP, TP EUR9.3) are value plays at 0.6x, 0.8x and 1.0x, TBV, 17E, respectively.

Equity Research – Credit Suisse