Our Europe-focused mutual fund has consistently stayed away from investments in the European financial sector. Why? European banks and insurers tend to fall short of our measures of a quality business – based on our research, we believe they have lower growth profiles and lower returns on invested capital and tend to offer undifferentiated products. We have differed greatly from the index in this regard, and as a high-conviction investor, I’m very comfortable with that.
Why do we consider European banks unattractive investments? Let’s take a deeper look.
Comparing banks: Europe vs. the U.S.
To demonstrate the differences between reported capital levels and underlying leverage across European and U.S. banks, let’s compare the reported common equity Tier 1 (CET 1) ratios and underlying leverage1 levels (equity divided by assets1) of two leading global Europe-based investment banks, Deutsche Bank and Société Générale (SocGen), with two U.S. peers, JPMorgan Chase and Goldman Sachs. What is the CET 1 ratio? Simply put, it is a commonly used measure to assess a bank’s financial strength – it compares a bank’s core equity capital against its total risk-weighted assets. Here, I will review this measure along with the banks’ leverage.
At the end of 2015, all four banks report almost identical CET 1 ratios under the Basel III guidelines2 – Deutsche Bank, SocGen, JPMorgan and Goldman Sachs reported 11.1%, 10.9%, 11.6% and 11.7%, respectively. However, the four carry vastly different leverage levels, based on assets3 divided by tangible equity. Deutsche Bank, SocGen, JPMorgan and Goldman Sachs exhibited leverage levels of 18.9x, 19.3x, 13.5x and 12.1x, respectively.4
Why do all four banks report comparable CET 1 capital ratios, yet the two European banks exhibit significantly higher levels of underlying leverage compared to their U.S. counterparts? The difference is significant – Deutsche Bank operating with 40% and 57% more leverage than JPMorgan and Goldman Sachs, respectively, and SocGen, operating with 43% and 60% more leverage than JPMorgan and Goldman Sachs, respectively.4
The discrepancy arises from the fact that the European banks assign considerably lower risk weights to their assets when calculating their CET 1 capital ratios. But are Deutsche Bank and SocGen’s assets really significantly safer than those of JP Morgan and Goldman Sachs? In my opinion, this assertion is highly implausible. All four institutions operate similar, large global investment banking businesses, but in my view the corporate culture and risk management practices of JP Morgan and Goldman Sachs are widely recognized in the industry as safer than those of Deutsche Bank and SocGen.
If variances in asset risk do not account for the inconsistencies in risk weights applied by the European and U.S. banks, why is there such a material difference?
Basel II A-IRB – what is it and what does it mean?
Beginning in 2007, European banks adopted the Basel II advanced internal ratings based approach (A-IRB), which allowed them to create and use their own internal models to determine the risk weights assigned to the assets they owned. Providing European banks with the discretion to set their own risk weights on their own assets using complex and opaque internal models, was akin to allowing the banks to grade their own homework.
In contrast, key U.S. regulators expressed material skepticism over an approach that effectively allowed banks to determine the riskiness of their own assets, given the inherent incentive banks would have to understate risk weights to bolster reported capital levels and returns on equity. Recognizing the limitations of any capital framework that assigns risk weights to assets, U.S. regulators maintained the leverage ratio (based on a simple calculation of equity to assets) to serve as a minimum floor for capital levels, which is much more challenging to game.
For example, Sheila Bair, former Chairperson of the U.S. Federal Deposit Insurance Corporation (FDIC), cited the noticeable expansion of European bank leverage following the implementation of the A-IRB approach and her fight to maintain the leverage ratio, in her book, Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself. In addition, Daniel Tarullo, a member of the Federal Reserve’s (Fed) Board of Governors and the Fed’s point person on financial regulation, exposed problems associated with A-IRB in his book, Banking on Basel: The Future of International Financial Regulation.
Due to the influence of these regulators, the U.S. deferred and never fully implemented the A-IRB approach. Both the leverage ratio and strict limitations on the application of risk weights to assets have generally led to much more conservative and prudent capital levels among U.S. banks.
To address the recurring questions surrounding the capital adequacy of the European banking system, regulators need to abandon the A-IRB approach, adopt and enforce a meaningful leverage ratio and compel European banks to raise the capital necessary to meet these more stringent capital requirements. However, even if the aforementioned regulatory reforms were made, many European banks’ business models may not be viable, in terms of generating returns on equity in excess of a reasonable cost of capital in an environment with higher capital levels and persistently low interest rates.