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Stock Strategist Industry Reports

Energy Exposure Shouldn't Tank Most Banks

We think the potential losses are manageable for most of the U.S., Canadian, and European banks we cover.

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After rounding up first-quarter earnings updates, we remain convinced that exposure to energy remains manageable for most U.S., Canadian, and European banks. We see positive indicators for investors on four fronts.

First is the strength of underlying markets. The price of Brent crude oil has risen to nearly $50 per barrel from below $30 in early January, alleviating pressure on oil companies and reducing the likelihood of default.

The second indicator--that market expectations of losses have lessened significantly--is related. In February, we noted that the S&P 500 Energy Corporate Bond Index (essentially all investment grade) was projecting losses of about 15%, while the Bloomberg USD High Yield Corporate Bond Energy Index (junk) was projecting losses around 30%. These indexes are now projecting losses of 5% and 20%, respectively.

Third, enhanced disclosures show that banks' energy exposure tends to be high quality. Among the U.S., Canadian, and European banks that we cover, around 59% of credits are high quality (investment-grade or similar at the 58% of covered banks that provide quality metrics).

Finally--and perhaps most important at an absolute level--energy exposure remains low and manageable relative to banks' common tangible equity. We estimate that 15% energy losses would consume an average of 3.1% of common Tier 1 equity. For a bank earning a 10% return on equity, that's one quarter's worth of earnings--clearly not a material threat to capital strength or bank moat ratings. Current market projections (losses of 4% on energy exposure) make potential additional write-downs look even less threatening, averaging near zero for U.S. banks and just 1% of common equity Tier 1 capital for Canadian and European banks. We still think investors should take advantage of market worries to invest in  Citigroup (C) and  Toronto-Dominion Bank (TD)/(TD), which are among our top investment ideas; both are significantly undervalued and face no significant threat from a renewed fall in energy prices.

Taking a more granular look at the first-quarter data, we see two interesting results.

First, U.S. banks, which report under U.S. generally accepted accounting principles, tend to be much better reserved for energy losses than Canadian and European banks, most of which report under international financial reporting standards. At the U.S. banks we cover, we calculate that reserves are sufficient to cover 44% of potential losses in a 15% loss scenario, with coverage ratios ranging from more than 60% at  Wells Fargo (WFC) and  Huntington Bancshares (HBAN) to a still-reasonable 30% at Citigroup and  Bank of America (BAC). In contrast, at the Canadian banks we cover, reserves are sufficient to cover just 5% of losses in a 15% loss scenario, with coverage ranging from a high of 12% at  Royal Bank of Canada (RY)/(RY) to a low of 3% at  Bank of Montreal (BMO)/(BMO). Disclosed energy-specific provisions at the European banks we cover are essentially nonexistent, leaving these banks still fully exposed to potential losses. To be fair, we should note that this gap in provisioning springs from differences in how the two accounting standards require banks to recognize losses. U.S. GAAP recognizes expected losses, while IFRS recognizes only incurred losses. These standards are expected to largely converge in 2018, when IFRS rules will change to require banks to recognize lifetime expected losses.

Second, while average exposure to energy is manageable, some banks have significantly more exposure than others. None of the banks we cover would face losses equivalent to 10% of common equity Tier 1 capital, or a full year's earnings for a bank earning a 10% return on equity, in a 15% energy loss scenario, but a few are close. We're particularly concerned about  Standard Chartered (STAN), where a 15% loss on energy loans could consume 9.3% of common equity Tier 1 capital, and  Cullen/Frost (CFR), where this loss could be 8.1% of common equity Tier 1 capital. In the case of Standard Chartered and many European banks, there may not be much in the way of near-term earnings to offset these losses, and capital raises or other long-term setbacks could result. We also call out  National Bank of Canada (NA),  BNP Paribas (BNPQY)/(BNP),  Bank of Nova Scotia (BNS)/(BNS), and  CIBC (CM)/(CM) as more exposed, with potential 15% losses consuming 5%-7% of common equity Tier 1 capital. We think all of these banks will be able to muddle through if today's improved conditions persist, but they could face devastating losses of 10%-20% of common equity Tier 1 capital if losses were to rise to a 30% worst-case level.

Erin Davis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.