Lately, there has been increasing speculation regarding the results of the AQR (Asset Quality Review), which will be published by the ECB in about a month time. The AQR is a central part of the “comprehensive assessment” investigation that the ECB is leading on European banks balance sheets. Working in conjunction with the national competent authorities (NCAs), it is a “financial health check” in order to provide an outcome on the financial solidity of the banks and, in case of capital shortfalls, force them to plug any capital hole. One may argue that Europe has botched previous banking turnaround exercises, like the stress tests led by the EBA (European Banking Authority) in 2011, which were attacked as being too soft. However, this time will be crucial to the reputation of the ECB’s new Single Supervisory Mechanism, which takes over regulation of major banks in November. For this reason, several European banks have proceeded to capital increase operations in order to consolidate their financial position ( ahead of the tests (approximately €47bn of capital have been raised since July 2013).
On September 18th, the first take up of funds made available by the TLTRO programme started and it resulted in a much lower than expected demand: European banks borrowed only €82.6bn vs. €150bn expected by analysts. Consequently, despite many investors worrying about banks’ lack of confidence in increasing loans demand, we believe that there will be a greater demand in the December round as banks plan their lending priorities for the new year and worries over potential capital shortfalls from the AQR have settled.
Technically, the assessment has been conducted on the 2013 closing balance sheets, while the capital raised during 2014 will be made clear in disclosures by the authorities. Other vaguer balance sheets exercises, such as sales of portfolios or business units or cost cuttings, will be considered on a lesser extent more qualitatively speaking than quantitatively. For this reason, the main key elements used to evaluate the banking sector have become the financial solidity ratios, such as the Core Tier 1 Basel III fully phased or the Coverage Ratio of the NPLs (Non-Performing Loans), in order to get a target ratio on the Tangible Equity and consequently a Target Price.
Hence, since the TLTRO is targeting SMEs, on which the Italian economy has always relied, and, on the other side, a possible QE by the ECB is highly probable if the loan demand will still be low, it results in a win-win situation for the Italian banks stocks. Therefore, we conducted an evaluation analysis on the largest Italian banks, Unicredit (UCG) and Intesa San Paolo (ISP). The Italian “popolari” banks, instead, are recently appraised also on M&A speculation and risks of capital shortfalls resulting from the AQR, thus they are not included in this study.
The main result of our analysis is that market is currently pricing a considerable discount on UCG (P/TE 0.736) compared to ISP (P/TE 0.893).
Firstly, the relatively higher exposure of UCG to Eastern Europe has played a key role in the pricing of the stock. However, the resolving situation of the region should slowly close the gap between the two banks.

Relevant ratios T12months (Source: Bloomberg)

Secondly, on the asset quality side, ISP has consolidated a strong Core Tier 1 Capital Ratio of 12.2% with respect to the 10.48% ratio of UCG, while enjoying also a lower level of Non-Performing Loans to Total Assets of 9.12% with respect to the 10.19% of UCG. Nevertheless, going into deeper calculation, the Loan Loss Reserve to NPLs ratio resulted in a considerable higher value for UCG (54.88%) rather than ISP’s (50.38%). This is due to UCG’s huge amount of provisions for loan losses set aside during the closing of the 2013 balance sheet (almost €14bn). After some simple algebraic calculus, a combined level of (Equity Tier 1+ LLR)/TA actually resulted in a level for UCG (16.07%) that is not much distant from ISP’s (16.79%) as the stock prices would seem to lead. One may argue that calculating a combined level makes the ratio in some sense “dirty”. As a matter of fact, it is not completely appropriate to combine an expected loss reserve with the “unexpected” loss measure covered by equity, but we believe that UCG has a different approach in their internal risk management models, preferring to allocate a higher proportion to reserves rather than equity (so making the data still be a good approximate of the financial solidity of the banks). Hence, this result shows us that UCG’s actual financial solidity (relative to ISP) is currently mispriced by markets.
Finally, on 18th September, UCG demanded for €7.7bn of TLTRO funds compared to the €4bn demanded by ISP. These funds, if compared to the level of total loans of each bank, represent a considerable higher percentage for UCG (0.15bps) relative to ISP (0.11bps), meaning a stronger confidence in the loans’ demand boosting the income for the former.
To sum up, thanks to improvements in Eastern Europe situation, its financial solidity and the apparent stronger confidence in the loans demand through the take-up of TLTRO funds, we recommend a spread trading strategy consisting in Long UCG / Short ISP in view of a closing discount between the two stocks to at least the pre-Ukraine crisis level. In detail, since we are bullish on the Italian banking sector, the short position on ISP is a hedging strategy in order to limit the downside risk of the trade rather than a profit looking short selling. Since it is a spread strategy, there is no specific time horizon, but possible news that can spark a revaluation of relative prices can be:
– Early November: AQR results clearly highlight differences between the two banks financial solidity
– December: second round of TLTRO funds take up
– Undefined: some possible announcements about definitive resolution of Ukraine’s crisis
– February/March: rumours about the new guidance for the coming year

CIX Index: UCG Price/ISP Price, 1 Year, Daily prices (Source: Bloomberg)

– Bloomberg
– Sole24Ore

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