Financial Services: Bank Worries Are Overdone

• We think that the market's panic over the potential impact of oil prices and Russia on banks is overplayed, and we see the current dip in share prices as a buying opportunity. Our top pick is  BOK Financial (BOKF), which is trading at a rare discount to our fair value estimate. Its significant exposure to energy means that we project losses of 4.9% of common equity in our stress test. While we see this number as manageable for the well-capitalized bank, we think actual losses are likely to be far lower given the bank's conservative energy portfolio.
• In our stress case, banks that we cover experience easily manageable losses from low oil prices and turmoil in Russia. In this scenario, which assumes 5% losses on energy exposures and 15% losses on Russian assets, losses would be the highest at  Societe Generale (GLE), at a painful but manageable 5.1% of common equity, and would average 1.7% of common equity across covered banks with known exposures. 
• Our worst case assumes an extreme scenario in which all banks experience historic losses on oil and Russia for the market's fears to be realized. Only five banks (BOK Financial,  Commerzbank (CBK), Societe Generale,  Standard Chartered (STAN), and  Cullen/Frost (CFR)) face potential losses greater than 15% of common equity in our worst-case scenario, which assumes 25% losses on energy exposures and 50% losses on Russian assets. An additional five banks ( Crédit Agricole (ACA),  Zions (ZION),  Comerica (CMA),  Barclays (BCS), and  Royal Bank Of Canada (RY)) face potential losses of greater than 10% of common equity. These loss rates are not based on average loss rates during past crises but on extreme individual examples of poor risk controls during these crises, and they are very unlikely to be realized, in our opinion.

Morningstar's view is that the decline in oil prices is likely to prove a short-term phenomenon. With U.S. producers drastically reducing spending in 2015, production growth is set to meaningfully slow this year and could even decline in 2016 if prices remain weak. Our longer-term expectation of continued global demand growth leads us to believe that Brent oil prices will again be around $75 per barrel by 2018. It's our view that this is the minimum price necessary to ensure adequate supply over the medium to long term.

However, we acknowledge that future prices, as well as producer behavior across markets, can be difficult to accurately predict. Although prices rebounded quickly after their sharp fall in 2009, in other times, banks have not been so lucky. We therefore believe it is prudent to consider what bank-level loan losses might look like in a stress scenario in which energy prices remain depressed for a prolonged period. We therefore estimate potential losses for both a stress-case and worst-case scenario.

In our stress case, we assume that banks experience 5% losses on energy loans, that 10% of energy commitments are drawn and that banks experience a similar 5% loss rate on these, that banks lose 50% of oil-related investment banking revenue, and that losses on Russian assets hit 15%. In this scenario, we estimate that, on average, covered banks with known exposure to energy or Russia would experience losses of 1.7% of common equity. We're comforted by the results of this scenario, which project that even the most exposed bank, Societe Generale, would experience manageable losses of 5.1% of common equity.

Our worst-case estimates are also drawn from the historical record, but instead of assuming that banks experience average losses, we assume that all banks experience losses in line with the much more extreme historical examples. In this scenario, we assume that energy losses reach 25% of loans, that 50% of commitments are drawn and that these, too, experience 25% losses, that banks lose 100% of oil-related investment banking revenue, and that Russian losses hit 50% of assets. In our worst-case scenario, we estimate that the same set of banks would, on average, see more painful losses, averaging 8.7% of common equity. It is only in this extreme scenario that we project that any covered banks would experience losses severe enough to cause capital shortfalls: We project that 10 banks (Barclays, BOK Financial, Comerica, Commerzbank, Cullen/Frost,  Nordea (NDA SEK), Royal Bank of Canada, Societe Generale, Standard Chartered, and Zions) could see losses of greater than 10% of common equity. Reassuringly, however, the remainder of the banks are projected to see manageable losses averaging 4.2% of common equity.

Top Financial Services Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
Apollo Global Management		$42	Narrow	High	$25.20
Lloyds Banking Group		$5.80	Narrow	High	$3.48
Santander Brasil		$7.50	Narrow	High	$4.50
Data as of 3-26-2015

 Apollo Global Management (APO)
Apollo is a global alternative asset manager with about $160 billion in assets under management deployed across private equity, credit, and real estate strategies. Notably, it manages AUM for Athene, a fixed-annuity provider, which provides Apollo with a $60 billion-plus source of permanent capital. We believe the market is overly focused on the short-term health of the IPO market and the near-term pace of realizations, and is overlooking the strong growth prospects Apollo has in credit, thanks to regulators forcing banks to sell illiquid and risky assets to the firm at a discount.

 Lloyds Banking Group (LYG)
We think Lloyds has finally turned the corner. In 2014, it reported its first annual profit in five years, declared a dividend (its first since 2008), and outearned its 10% cost of equity, with an underlying 13.6% return on required equity. We expect results to continue to improve: Net interest margins will strengthen as noncore operations run down, and shareholders will finally see the benefit of Lloyds' strong competitive position in the United Kingdom's profitable retail banking market.

 Banco Santander Brasil (BSBR)
We think Santander Brasil is undervalued because investors are overly focused on headline profitability metrics that do not capture the true earnings power of the company. In our view, Santander Brasil holds a strong competitive position in the highly concentrated Brazilian banking market with a narrow economic moat. We expect that the negative accounting impact from goodwill and excess capital will fade, and over the long term, investors will come to realize the bank's true earnings power.

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