Europe Retail Banks Seen Gaining Most From Lower Loan Losses

As bad-loan provisions at European banks start getting smaller, some analysts are betting that banks with strong retail franchises will benefit the most and lead the next stage of the ongoing rally in financial stocks.

That's at odds with the prevailing wisdom that banks specializing in commercial and investment banking are in better shape to keep beating earnings forecasts because of strong volumes this year in areas including bond sales and currency trading.

"We think the real driver of earnings upgrades in the medium term will be the provision line - which argues for an overweight retail stance," Derek De Vries, an analyst at Bank of America Merrill Lynch, wrote in a research note Tuesday, naming banks such as Danske Bank A/S (DANSKE.KO), Nordea Bank AB (NDA.SK) and Skandinaviska Enskilda Banken AB (SEB-A.SK) as big beneficiaries of lower provisions.

Adding to his argument is the likelihood of stricter regulation for investment banks that would require them to hold more capital, and the assumption that a lot of good news is already priced into wholesale bank shares.

JPMorgan analysts made a similar judgment in September, and Monday highlighted HSBC Holdings PLC (HBC), UniCredit SpA (UCG.MI), Societe Generale SA (GLE.FR) and Banco Bilbao Vizcaya Argentaria SA (BBV) as some of the banks with potential for earnings upgrades over the next 18 months if loan losses come in below expectations.

"We expect P&L dynamics to improve significantly for traditional credit banks, as loan losses start to improve sharply from 2011 at the latest, more than offsetting any margin pressure on revenues," JPMorgan said.

So far this year, wholesale banks such as Barclays PLC (BCS), Credit Suisse Group (CS) and UBS AG (UBS) have rallied 27 percentage points more than their retail peers - rising by 87% vs. 57%, according to the BoA/Merrill note, citing Datastream. From low expectations, analysts have lifted their collective forecasts on wholesale banks by 30% so far in 2009, BoA/Merrill says, as high client trading volumes and the positive effects of a steep yield curve on margins helped to offset loan losses.

The good news isn't seen coming to an end - BoA/Merrill is expecting another strong result from Credit Suisse and some of the other wholesale banks when Europe's third-quarter reporting season starts this week - but the prospect that loan losses have peaked, or will peak soon, should be of bigger benefit to retail banks.

According to De Vries' analysis, Europe's main retail banks including Banco Popular Espanol SA (POP.MC), BBVA, HSBC and Banco Santander SA (STD), have the most to gain in their earnings when provisions return to historic norms, though the bank is still cautious on Spanish banks because of the country's troubled economy.

Meanwhile, Moody's Investors Service in a note Monday said European banks face significant ratings downgrades if they don't clean up their balance sheets and strengthen their stand-alone credit profiles before the "extraordinary systemic support" they're enjoying from central banks and governments is withdrawn.

-By Margot Patrick, Dow Jones Newswires; [phone]; [e-mail]