Credit analyst Toby Williams considers whether European banks are off the ropes. Will they keep going the distance?
Peripheral banks are banks operating in non-core European countries such as Spain, Italy, Ireland, Portugal and Greece. These underdogs have shown remarkable resilience and growth in the post-COVID era, especially throughout 2024.
This economic strength contrasts sharply with the sluggish pace of their heavyweight counterparts in core European economies like Germany and France. In addition, an upsurge in geopolitical tensions is driving uncertainty in financial markets and has led to investors seeking stronger economic fundamentals.
Fundamentals are improving most quickly in the so-called peripheral economies, and with banks seen as levered plays on economies, subsequently right into the arms of peripheral bank paper. This mass flocking to strength and value has led peripheral bank spreads to tighten significantly in recent times.
The Rocky Montage: Back up off the canvas
Picture this next part with the Rocky theme tune in your head. Think how he gets faster and stronger during his training montage. You will then have a good mental frame of mind to think about the hard journey of these peripheral economies back to being the fan favourites.
A major driving factor in this trend has been the drastic and sustained improvement in the underlying local economies. Unlike prior cycles, the post-pandemic recovery has been characterised by high growth, and there are several reasons for this recovery and growth.
2021 saw the allocation of funds from the EU’s Recovery and Resilience Facility (RRF), which was created as a tool by the EU to ensure economic stability within its weaker member economies.
Peripheral European economies were major beneficiaries of this scheme with access to large-scale grants and low-cost loans. These allocated funds have been pointed towards infrastructure, digital transformation, and green energy projects. Greece has been allotted €36bn in funding, in which only €18bn has been dispersed into the economy so far.
Governments in peripheral Europe have used and are planning to further disperse COVID-era funding not only to stimulate growth but also to reduce their debt burdens allowing these economies to deleverage further, providing solid platforms for growth. This fiscal discipline has reduced sovereign risk, which directly benefits banks by lowering funding costs and improving investor confidence in the region’s financial stability.
In 2024, we have seen peripheral economies enjoy the purse from this deleveraging, where we expect them to have outpaced core European economies in terms of real GDP growth. According to preliminary estimates, Spanish GDP grew 3.5% year over year. Similarly, Portugal, according to those same estimates, has grown 2.7% in the past year. These numbers sit in stark contrast to those of Germany (which contracted -0.2% in the year) and France, whose economy is expected to have expanded only 0.7% in the year.
Another key feature of the deleveraging and economic growth seen in these peripheral economies is it has allowed the banks operating in these local economies to significantly reduce the NPL (non-performing loans) burden which had developed during prior idiosyncratic economic events. Alongside accommodative government schemes aimed to help banks reduce NPLs, we have seen banks in Greece reduce their NPL exposure down to below 5% on average, which is still higher than in core Europe, however in comparison to the levels seen in Greek banks in 2016 (c.40%) this is a drastic improvement – and aids the banks in doling out new loans to the economy, further helping it to grow.
The Bout so Far: From journeyman to undisputed champs
One of the most standout trends seen in the credit markets in 2024 was the strength of performance of peripheral bank paper across the capital stack. When looking back in history, these banks used to have to offer investors a significant risk premia to gain investment due to political instability, economic weakness and extreme levels of non-performing loans (NPLs).
However, over 2024 we saw the erosion of this risk premia to new primary bond issues being priced in line with core-European banks. In the primary markets, notably, Eurobank (Greece), Banco BPM (Italy), and CaixaBank (Spain), have recently placed subordinated paper at very competitive levels, with orderbooks that were significantly oversubscribed.
As mentioned before, the recovery of these peripheral economies, and most notably the recovery in the worst positioned of these economies, such as Greece and Portugal, have been incredible. NPLs are down, economies thriving, resulting in drastically improved fundamentals.
Time to retire or Rocky V?
All of this has culminated in much tighter credit spreads on offer across the capital stack of these peripheral banks. If you look at senior unsecured spread levels, notably Senior Preferred and Senior Non-Preferred, you can see the spread between these bonds and the underlying Bund equivalent tenor has compressed to pre-financial crises levels, showing investors have gotten extremely comfortable wearing this peripheral risk.
Further down the capital stack in the subordinated Tier 2 and Additional Tier 1 capital levels, we have seen outsized performance on these bonds post the collapse of Credit Suisse. The wide spreads of the peripheral banks combined with improving investor sentiment resulted in the strong performance seen in capital instruments in 2024. We are now seeing new capital instruments issued out of peripheral banks at levels touching those of core European tier 1 banks.
The Final Bell
It is very hard to see where and how peripheral bank spreads can go from here. It is likely that the tightening has, for the most part, made most of its move. It is hard to see these peripheral banks permanently trading inside the levels of the core-European banks, which are much bigger and have levers to pull in any economic downturn. Although there could be pockets of opportunity within some of the smaller less well covered peripheral banks. That may present some opportunities from compression as investors take time to get comfortable with the name. As well as this, idiosyncratic opportunities are also continually presenting themselves.
In recent times we have seen a surge in M&A activity across Italy’s banking sector, with some heavyweight players throwing their hats into the ring for smaller domestic counterparts. This consolidation activity is evidenced by the recent Unicredit bid for its competitor Banco BPM, BPER Banca’s bid for Banca Popolare di Sondrio and Monte Dei Paschi hostile bid for Mediobanca. If even some of this consolidation proposed goes ahead, it will create fewer and larger institutions. This is a credit positive for these banks, as it allows them to compete with the larger scale international peers and create more cost-efficient structures. However, we do also have to be aware that whilst some banks will grow through consolidation, this will also create difficulties for smaller peers who do not carve out a niche, as they will struggle to compete for business.
As mentioned above, we have not seen the full disbursement of the post-covid funding, and the majority is yet to flow into these economies. So, we can only expect further improvements in the economic condition of these countries. Yet, there are global trends which we need to be cognisant of. President Trump and the proposed Eurozone tariffs could cause disruption for local players in these peripheral countries where they are keen exporters. In addition, any spillover to these economies from a downturn in European industry and higher energy costs are also a risk for these economies too.
In conclusion, whilst most of the big spread moving has occurred already, these ‘underdogs’ continue to be large beneficiaries of inflows from European recovery flows. In addition to the structural changes in the local economies, these economies and banks are likely to continue to be resilient versus their larger peers. Taking a step back, peripheral economies have proven they can go the distance, showing less weakness compared to their faltering core-European peers. Their spreads may be tight, but they still pack a punch. We believe they are deserving of consideration for a spot in investors’ portfolios. After all, if not here, then where?
Toby Williams, Credit Analyst
