Michael, we've just had a lot of noise about US banks. How are the Europeans doing? Is the worst over? 

It's a very good question. There's been very little noticeable spillover from their peers in the US. They're two very different banking sectors in terms of structure. The European sector is much more highly monitored and regulated, whereas there has been a lighter touch approach in the US, which is to some extent a driving force behind what we've seen over the past couple of months. 

The Europeans look stronger?

Aside from obviously a blip in Switzerland, we’re coming out of a first quarter of results where most of the banks are seeing improving metrics, which is a story that hasn't meaningfully changed. And we don't expect it to meaningfully change in the short to medium term. 

Meaning the banks may be undervalued at the moment, particularly as credit? 

I think there is still a lack of confidence in the sector from the way at least bank credit is being priced. They are still trading wide to non-financial corporates in Europe and there is still a bit of a valuation gap there. There's a hesitancy, particularly after Credit Suisse, for issuers to return to the market. So it does seem to be a cheap sector at the moment: these are good quality credits. 

For “quality”, you mean: debtors I can rely on as the recession hits…

Within Europe, there are still high quality names that are improving profitability on higher interest rates, with very low default levels on their balance sheets. So yes, there is a high quality play there. 

And this after chief executives in the banking sector complained about overregulation. 

There is a view out there now that the European Central Bank (ECB) and European regulators have done a good job. They implemented a raft of banking regulations over the past 10 to 12 years, to the annoyance of some of these banks, who complained about over monitoring and being overly constrained around profitability when their US peers have been a bit more free to increase their returns on equity. 

Every single bank the ECB looks at is required to report on liquidity ratios, on LCR (liquidity coverage ratio) and SFR (stable funding ratio) - the two ratios that have become so popular over the past couple of months. These banks cannot conduct themselves in the same manner as some banks in the US. 

Sometimes it's good when banking is boring. 

Particularly from a credit standpoint! Yeah, it's not necessarily a bad thing. 

What's the trajectory for banks’ results from here? 

It's a bad answer, but it really depends. There are some banks that are now starting to see their earnings trajectory taper out. The last 12 months has seen interest rates going up. That's really good news for banks. They can start to get more yield from the loans that they give out. But that trajectory, as I said, is slightly tapering off. 

The main reason for that is deposit pricing. Very early on in the cycle, banks saw deposit rates staying pretty much flat. Now deposits are getting a bit more competitive amongst banks in Europe and they are having to be a bit more aggressive in how they price those deposits. Hence their margins at the top end are getting a bit more squeezed. 

What happens next? 

The ECB Bank Lending Survey, which surveys the loan managers of European banks, has pointed to a strong decrease in demand from both corporates and individuals for loans. So naturally, as banks want to do what they do, which is give loans to customers, they will have to try and again be a bit more aggressive in their loan pricing. And when you add the deposits situation, then you get tighter margins generally. 

How much of a risk is commercial real estate (CRE) for European banks? 

It's not something at the moment I’d say is material for the credits that we look at. Banks’ LTV (loan-to-value ratio) for CRE is very low indeed. The risk-approaches have meaningfully changed over the last 10 years. And again, regulators have already penalised a number of banks on their capital requirements because of their exposures to CRE. 

But it has been material for stock and credit pricing. 

I think there's a bit more comfort around that sector. We've seen a lot more detail and disclosure by European banks around their portfolios. We've managed to get a lot more understanding of exactly what those exposures are, and exactly what the risk approaches are from their internal management. It's not a blasé, absolutely fine situation, but it's certainly not something in the short term that causes us material concern for the banks we look at. 

Non-performing loans. Is that beginning to show up? 

The short answer is not really. ‘Why not’ is a question that I don't think many management teams have a clear answer to. Banks have been prepared for close to two years for a material increase in delinquency. They had big risk provisions built up over COVID. Those provisions weren't really needed and have been carried over. So many of these banks still have very large buffers of risk provisions. Yet we have been waiting for the past two years and nothing's really materialised. 

Maybe there's more elasticity in the economy than we really appreciate.

Possibly, yes. Fiscal support, the energy price caps, and government support schemes have all had a material impact on both consumers and for small businesses and large corporates as well.