Overreaction to banks’ Russian exposure

As investors are urged to reposition, holding subordinated bank debt could be worth it.


European bank stocks have been among the hardest hit asset classes since Russia’s invasion of Ukraine as fears of losses and a flight to quality prompted investors to reposition. This reaction is exactly what one would expect in the current environment: in general, banks have always been perceived as high-beta risky positions, and investors believe that a strategy of “sell now and put questions later” will pay off in the short term as risk aversion sentiment pervades the market.

Risk aversion offers an opportunity

In the bond markets, subordinated bank debt is also among the most affected sectors with a loss of 7.31% since the beginning of the year for the ICE BofA Contingent Capital (Coco) index, which corresponds to a broadening of the spread of 151bp. In fact, the yield in this sector soared to 5.69% on Tuesday, compared to just 3.02% last September. Even lower-rated junk debt has outperformed subordinated bank bonds, with returns of -3.95% in the US high yield sector and -5.15% in the European high yield sector year-to-date.

Russian and Russia-related credit exposures are unlikely to overwhelm the European banking system.

While this natural risk aversion makes sense in today’s market, we believe it is not supported by fundamentals and ultimately should provide an opportunity for investors. In our view, Russian and Russia-related credit exposures are unlikely to overwhelm the European banking system. The current momentum also reminds us of the period between late 2015 and early 2016: fears of losses linked to falling commodity prices triggered a similar correction in bank debt, which was then seen as the next catalyst for a new financial crisis. We know today that this was not the case; the banks very quickly adapted their exposures to the sector and a vigorous recovery followed the correction.

A well capitalized exposure

European banks’ Russian and Russia-related credit exposures are extremely low – estimated to be less than 1% of total exposures across the sector. It should also be noted that the risk weights that banks must apply to Russian assets are high, which means that these exposures are also well capitalized. Societe Generale in France and UniCredit in Italy are making a lot of noise with their large exposures, but these seem to us quite manageable in the context of their very high capitalization levels.

Investors looking to add to their positions will likely benefit from increased coupon payments and medium-term capital gains.

According to Bloomberg Intelligence, a full write-off of Russian exposure at SocGen and UniCredit would result in only a 30bp drop in each bank’s Common Equity Tier 1 (CET1) ratio. Looking at some outstanding bonds, SocGen’s four-year AT1 in dollars was trading near 8% on Tuesday morning, and UniCredit’s 5-year AT1 in euros was also close to 9% (which would be close to 10.5% in dollars): in our opinion, these levels really do not reflect the real credit risk involved in exposure to two of the main European banks. We can understand that the high exposures of these banks to Russia could have an impact on their profits, but an actual amputation of their capital seems unlikely to us, including in a scenario where European GDP would suffer from the imposed sanctions.

Patience could pay off

It is very difficult to make predictions when geopolitical events dominate the news, and even more difficult to know when the bottom of the wave will be reached in the markets in the face of such a changing situation, but we do not think there is need to panic about holding subordinated bank debt. On the contrary, in our view investors should be rewarded for their patience and those looking to add to their positions will likely benefit from increased coupon payments and capital gains over the medium term.

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