What's in store for international banks?

Despite their reputation as risky bets, many emerging-market banks--along with their countries' economies in general--fared much better during the last two years than their more "developed" cousins. Even within the developed world, there are dramatic differences between the performance of banks that took on too much risk and those that did not, with some banks having nearly destroyed their businesses and others winning market share as their rivals struggle. We think the significant divergence among international banks during the last two years will extend into the recovery, and we expect to see stark contrasts between the winners and the losers in both the speed and strength of their recoveries.

Brazil
After they reported third-quarter earnings, the three Brazilian banks we cover--Itau Unibanco, Banco Bradesco, and Banco Santander Brasil--all displayed a common theme: The worst of the crisis may be over in Brazil. Together with Banco do Brasil, a government-controlled bank, they dominate Brazil's banking market. Although we think there are some convincing data points to support this optimism, we doubt that there will be a sharp recovery--especially with regard to credit quality.

Although nonperforming loans (NPLs) kept climbing across the board, they did so at a slower clip. The pace at which net new NPLs are forming has been constantly declining since early 2009. Hence, we think that in the near term we should start seeing NPL balances actually declining. Another heartening indicator was the fall in early delinquencies--loans overdue between 30 and 60 days. That said, though it is commonplace for banks in emerging markets to have high bad-loan balances that are compensated by fat interest margins, we think NPLs of around 7% or more are no laughing matter. To be sure, even though nonperforming loans may start to trend down, actual loan losses should remain higher than usual for some time, which will pressure banks' bottom line, in our view.

Notwithstanding, Itau's and Bradesco's profitability has shown signs of resilience, with returns on equity staying around 20%. For these two, we think that after a couple of quarters or so, we should start seeing returns creeping back to their former levels of around 25%. The laggard, Santander, still has to cope with higher bad-loan balances and provisions to replenish its reserves which will prevent it from enjoying as speedy a recovery as its competitors. Further, it has by far the fattest equity base, which quells its returns. Nonetheless, even comparing returns on assets, it is way behind.

A significant portion of Brazil's economic recovery--which arguably started in the second quarter--is because of the country's domestic demand, particularly from individuals. In our opinion, a growing middle-income class that consistently calls for more financial products will continue to provide fertile grounds for banks to profitably expand.

Switzerland
The results of Switzerland's largest two banks, UBS and Credit Suisse, continued to demonstrate the divergent impact of the financial crisis. Credit Suisse, which stayed away from accepting government support, has been profitable every quarter so far in 2009, even earning a return on equity of around 25% in the third quarter, as it benefited from its client-focused business model and solid reputation. So far this year, it has garnered net new asset inflows of more than CHF 30 billion, demonstrating its clients' faith in its solid private bank. UBS, on the other hand, has steadily reported losses, losing some CHF 4 billion thus far in 2009, as it suffered continued write-downs on its trading assets and a shrinking business. The damage done to its reputation, both by losses at its investment bank and numerous scandals at its private bank, shows up in its net new assets. In sharp contrast to Credit Suisse, UBS has so far shouldered net asset outflows of more than CHF 90 billion in 2009. We expect the banks' fortunes in 2010 to be similarly divergent--UBS will struggle to reach any profitability, in our estimation, while Credit Suisse will likely report profits near precrisis levels.

Ireland
A sharp fall in credit quality at Bank of Ireland in the half ended September 30 and at Allied Irish Banks in the half ended June 30 underscores that these once-mighty Irish banks are far from out of the woods. Ireland's dramatic slowdown--real gross domestic product is expected to shrink 7.5% in 2009 and housing prices have fallen 25% since their peak in early 2007--has hit its banks hard. One, Anglo Irish, was nationalised entirely in January, and AIB and Bank of Ireland face massive government bailouts, capital raises, and asset sales. Although there are some small signs of improvement--Bank of Ireland's loan/deposit ratio fell to 152% in September from 161% as of March 31, 2009--there's little that can counterbalance the growing weight of the banks' bad-loan portfolios. Troubled loans made up 10.6% of Bank of Ireland's portfolio as of September 30, and the figure is likely to be even higher at AIB when it next reports detailed results at year-end, given its larger portfolio of property and construction loans. The future of both banks looks highly uncertain. The European Union is likely to demand significant asset sales from both as a consequence of their dependence on state aid, and the banks are unlikely to ever again consistently post boom-years-sized profits.

United Kingdom
Across the board, declining credit quality negatively affected the results of Barclays, HSBC, and Royal Bank of Scotland, and we expect the pattern to continue at Lloyds Banking Group when it reports later this month. The weak UK economy--real GDP is expected to decline 4.6% in 2009--is dragging down all of the banks' results, but there were stark differences between the banks that have weathered the downturn in fairly good shape and those that have not. HSBC, buoyed by its exposure to China and emerging markets, said that pretax profits were strongly ahead of last year's numbers on a like-for-like basis, though it released few details. Similarly, Barclays said that profits more than doubled from last year's numbers, excluding one-time items, as it benefited from strong trading results. In contrast, Royal Bank of Scotland announced that the government would take up another £25.5 billion stake in the bank to help it cope with its rapidly declining credit quality. Shareholder losses have been almost £3 billion year to date. We expect this divergent performance to continue in 2010, as HSBC and Barclays report near-normalised results and RBS and Lloyds report losses.

India
In India, the superiority of HDFC over ICICI is as clear as ever, in our view. In part because of much better credit quality and wider interest margins, the former's returns have stayed at relatively healthy levels. Not quite 20%, but with returns on equity around 17%, they compare favourably with those of many other financial institutions, in our opinion.

ICICI is still losing deposits at an astonishing pace. Although the bank claims it is letting its most expensive deposits run off, we think that if it goes too far, it may have to resort to costlier debt to fund loan growth. So far, in contrast with HDFC, ICICI's loan balances have been quickly declining, but once demand kicks back in earnest, we think margins may contract if the firm's deposit-gathering efforts do not bear fruit.

As with many other emerging markets, signs of amelioration are starting to show mostly through plateauing NPL balances. India's economy is set to grow at an annual clip of between 5% and 6%. Even though this is still a ways from the 9%-10% growth rates it saw during the boom years, we think it is an interesting alternative that stacks up well against other emerging economies' growth rates.

Japan
Despite the return of profitability at both Nomura Holdings and Mizuho Financial Group we don't see many signs of progress at these Japanese banks, which appear doomed to eternally repeat their mistakes. Once lauded for initially avoiding the subprime contagion, Japanese banks found themselves also raising dilutive capital as the crisis continued, and we're not sure that these highly leveraged institutions are done stabilising their balance sheets. Mitsubishi UFJ is rumoured to be planning a capital raise of roughly JPY 1 trillion (£6.6 billion), a massive amount by any measure, after raising a similar figure within the last year. Furthermore, while Goldman Sachs returned to posting double-digit returns on equity soon after the financial crisis began to wane, banks like Mizuho returned to only a modest level of profitability after a multibillion dollar loss in its last fiscal year. Nomura picked up Lehman Brothers' Asian operations for a song last year, but it is just beginning to see benefits on the revenue side, while compensation costs have been taking a toll on results for some time. The disastrous combination of high leverage and low core earnings power will continue to take a toll on most of these institutions for the foreseeable future, in our opinion, and the country is continuing its long battle with deflation.

Korea
Across the Korea Strait, South Korea's Shinhan Financial Group saw small improvements in credit statistics, while KB Financial Group's third-quarter income suffered from increased provisioning. Both banks benefited from falling interest rates, improving their net interest margins by lowering rates on deposits and making loans at higher credit spreads. Although the Bank of Korea was widely expected to raise rates as the domestic economy improved--the country's economy grew by 2.9% in the third quarter--the central bank chose not to do so at its most recent meeting, potentially boosting both net interest margins and GDP growth in the coming quarters. Although the South Korean banks have historically shown higher profitability than their Japanese peers, they've been subject to some of the same disturbing herding tendencies as their neighbours. For instance, the country had its own financial crisis only a few years ago as a result of excessive credit card spending, yet credit cards remain a major focus of growth efforts at South Korean banks. There is certainly room for growth compared with the United States, which has a larger number of cards outstanding per capita, and delinquency rates remain low, but we're remaining cautious considering the country's recent history.

The winners
The financial crisis provided a graphic demonstration of the differences between high-quality banks and lesser performers, many of which are now out of business. However, opportunities have also been created for surviving institutions. We believe the following banks are best-positioned to profitably gain market share as the global economy recovers:

Barclays (UK)--Avoided government rescue, benefiting from Lehman acquisition

HSBC (UK)--Exposure to emerging markets propelling growth and profitability

Bradesco (Brazil)--Conservative lender deeply entrenched in Latin America's largest and brightest economies

Itau Unibanco (Brazil)--Very profitable bank with an appetite for more presence in Latin America

HDFC (India)--Highly profitable bank with good credit quality in a booming economy

Credit Suisse (Switzerland)--Strongest Swiss bank, gaining market share