The largely unexpected stock market rally that has occurred since the end of March, combined with the buoyant bond market and anticipated strong, albeit slower, loan growth, will most likely produce a good set of financial results for the larger Greek banks in the second quarter. Although it is not clear whether actual earnings will beat market estimates, leading to upward earnings revisions for this year and next, this development will confirm earlier forecasts of a bank profit recovery this year and give local banks the opportunity to strengthen their capital base and make valuation comparisons more favorable against their European peers. Undoubtedly, the strong performance of European stock markets in the last three months or so and the interest rate cuts delivered by the European Central Bank (ECB) in a bid to foster economic growth in the euro area, have brightened the prospects of the European banking sector. Although there are vast differences, with Greek and Spanish banks expected to experience much higher revenue growth than German, Swiss or Norwegian banks, there is an encouraging gradual improvement in the operating environment, with cost cuts and lower bad loan provisions compensating for poor top-line growth to boost operating and pretax profits. Of course, there are some who disagree with this assessment. Standard & Poor’s issued a report on Western European Banks yesterday, saying it remains pessimistic about a sharp rebound in 2003 financial results, saying «results in 2003 are likely to be affected by the potential for increases in provisioning.» Moreover, it expects significant unfunded pension liabilities on the back of «stock market turbulence» and higher pension costs to hurt profits and adds weak investment banking and wholesale operations to its list of concerns. It is known that Greek banks have grown accustomed to fat trading income, commissions and fees largely linked to the superb performance of the Athens Stock Exchange during the convergence process to join EMU in the late 1990s. The National Bank of Greece, the country’s largest bank, saw its non-interest income-to-risk weighted assets (RWA) ratio fall from 8.89 percent in 1999 to 1.90 percent at end-2002 based on UBS Warburg estimates. Alpha Bank’s slid from 8.75 percent in 1999 to an estimated 2.76 percent in 2002. Commercial Bank’s fell from 6.89 percent in 1999 to 1.81 percent in 2002 and Piraeus Bank’s dropped from 10.93 percent to 1.69 percent in 2002. The fall from 5.41 percent to 2.04 percent was less severe for EFG Eurobank Ergasias because of its comparatively lower exposure to capital markets. The dependence of Greek banks on stock market conditions becomes even clearer by looking at the evolution of dealing profits. Strikingly enough, National Bank’s dealing profits – a component of non-interest income – as a percentage of RWAs fell to an estimated 0.34 percent in 2002 versus 5.42 percent in 1999. Alpha Bank’s ratio tumbled to 0.37 percent in 2002 from 4.47 percent in 1999 and EFG Eurobank’s turned negative last year, meaning it incurred losses. This unfavorable trend has been partly neutralized by rising net interest income as local banks took advantage of much lower interest rates, unleveraged households and businesses, and a growing economy to expand their loan books and improve their assets mix by moving away from equities and bonds toward retail banking. Their ability to increase and preserve net interest margins in the face of growing competition and a gradual slowdown in loans has also boosted net interest income. But what goes around, comes around and Greek banks appear ready to gain both from strong loan growth rates and rebounding capital markets. The steep rise of the Athens bourse is expected to translate into higher trading income and asset gathering fees, as the latter are calculated as a percentage of assets under management. The higher the value of the assets, the higher the fees. Although analysts may disagree to the extent that gains from equities and bonds are recurrent, there is no doubt that dealing profits and fees as a percentage of risk-weight assets had hit very low levels and, therefore, a rebound to 2001 levels or 70 percent of that amount should not be viewed as non-recurrent. Although non-interest income from these sources is more volatile and unpredictable than net interest income, the mentioned levels are not high by historical standards. In addition, the unexpected rise in total revenues and profits, especially if it is sustained, could give banks an opportunity to reduce leverage and improve their capital base in a healthy way. It is to be remembered that high loan growth rates resulted in a sharp drop in capital adequacy as the sector’s Tier I ratio fell to 9.0 percent in 2002 from 15.66 percent in 1999, forcing some banks to leverage themselves via hybrids to keep their loan book expanding. Even if better capital market conditions allow Greek banks to produce better-than-expected earnings and improve their valuations against their European peers, this does not mean they should lay back and stop making gradual progress in containing operating costs. One may argue that better market conditions facilitate the implementation of existing voluntary retirement programs and gives them more time to pursue more aggressive policies of productivity enhancement to deal with staff costs, remaining among the highest in Europe in the case of Commercial Bank, as a percentage of RWAs. Commercial’s staff expense-to-RWAs is estimated at 3.08 percent in 2002 versus 1.59 percent at Piraeus Bank, 1.77 percent at Alpha Bank and 2.21 percent at EFG Eurobank. After three years or so, large Greek banks are on their way to posting strong second-quarter results, partially thanks to a rebounding Athens bourse. Although time will show whether this stock market rebound signals the end of the bear market, banks should capitalize on that to build their capital base and pursue more aggressive policies of productivity enhancement and operating cost containment to boost mid-term profitability and provide impetus for the stock market to rise even further.