SVKEF - Skandinaviska Enskilda Banken AB (publ) (SKVKY) Q2 2023 Earnings Call Transcript
2023-07-18 11:59:04 ET
Skandinaviska Enskilda Banken AB (publ) (SKVKY)
Q2 2023 Earnings Conference Call
July 18, 2023, 4:00 AM ET
Company Participants
Johan Torgeby - President and CEO
Masih Yazdi - Chief Financial Officer
Conference Call Participants
Namita Samtani - Barclays
Andreas Hakansson - Danske Bank
Magnus Andersson - ABG
Sofie Peterzens - JPMorgan
Nicolas McBeath - DNB
Rickard Strand - Nordea
Martin Leitgeb - Goldman Sachs
Geoff Dawes - SG
Piers Brown - HSBC
Riccardo Rovere - Mediobanca
Presentation
Operator
Good morning. This is the conference operator. Welcome and thank you for joining the SEB’s Second Quarter 2023 Results Conference Call. As a reminder, all participants are in listen-only mode. [Operator Instructions]
At this time, I would like to turn the conference over to Mr. Johan Torgeby, President and CEO. Please go ahead, sir.
Johan Torgeby
Thank you very much. And good morning and welcome to everyone to SEB’s summer quarter of 2023. As customary, we will go through a presentation which you can find on the Group website under IR.
Starting with the highlights on page two. Return on equity came in at 18.8% on a core equity capital ratio of 19.3% resulting in a 450 basis points buffer. Much of the activity was positively driven by large corporate customers. We saw both growing lending volumes and growing deposit volumes.
During the quarter, as we previously announced, we have entered into an agreement to acquire AirPlus from Lufthansa, which will further strengthening -- strengthen our corporate card business and help us in our expansion of our corporate banking business.
Asset quality remained very strong during the quarter and more or less no increase in expected credit losses was recorded and we will continue as previous quarters with a SEK5 billion per annum of a share buyback pace, resulting in the SEK1.25 billion for the next quarter.
Flipping to page three, some reasonable -- recent events. Firstly, it was very encouraging to see in the higher activity area of FX that the customer survey that is done once a year in the Nordics around FX that we ended up on top in the customer satisfaction score.
We have also announced a partnership with EQT in order to create a very more readily available investment product for the EQT, the Private Equity Firms -- Funds and making alternative investments more available and we have an exclusive arrangement for the next six months to do this together.
During the quarter, we also launched two new thematic funds. One is the Renewable Energy Fund, which is focusing on smaller infrastructure companies often overlooked by the large funds and energy companies. And of course, the interest in artificial intelligence, which we have all seen -- we have met -- we will meet with the new fund that particularly tries to capture that opportunity.
We have also had two significant changes in the digital capabilities within our pension solutions. One is to -- through the use of APIs provide a digital self-service that we have integrated with a wide variety of brokers. This is that fund that the pension investments that are done by third-party, which you can now enter into the SEB environment through APIs.
And the other is a real-time overview where you can collect all your pension contributions you might have in different places through -- in the mobile app of SEB and it has been done with the fintech partnership company Insurely.
Next page, we will talk a little bit about macro and starting with inflation, which is probably the most topical discussion right now. We can clearly see that we are probably at the end of the beginning of this new brave world.
So inflation rates are continuing to come down and the big debate is, of course, will we have one, two or three more hikes before we come in this fall, maybe early 2024 see a pause from the Central Banks and we will find a new equilibrium in the banking sector.
Rates have been range trading lately, but we saw a small uptick in the 10-year government yields in the U.S., but it has shown quite lower volatility and we have also seen a very resilient equity markets with falling VIX index. So falling volatility and it’s held up well.
On page five, we have tried to post a very familiar negative narrative around Sweden lately. So starting with maybe the most eye catching development is the development of the Swedish krona. The krona has depreciated 34% against the euro in the last decade and 56% against the dollar and 71% against the Swiss franc.
The last 12 months, we have also seen a depreciation versus the euro and the Swiss franc, and looking around in the world very few currencies we can find have shown a weaker pattern against those major currencies and we are, of course, a big bank in Norway as well, but Norwegian krona has shown a similar pattern.
The KIX, which is the trade-weighted average of the appreciation depreciation of the currency indicate a 23% depreciation in the long run and also in the last 12 months, a 4% depreciation. This is, of course, a very tricky and cumbersome environment and effects a lot of thing in a small open export-oriented country.
The other part is of course the effects from the higher interest rates and the leverage that we have seen on the commercial real estate sector. So here we had a peak of around the index in Stockholm around 600 falling down out to somewhere around the 250 area, so we are talking a 50% to 60% drop in the value on the stock market for the commercial real estate stocks.
We also talk about the relatively high household indebtedness and you can see that since the financial crisis of 2008, Sweden has had a growing household indebtedness compared to the disposable income.
That is to say that we have let borrowed more money than our salaries have increased and that makes us more vulnerable for interest rate increases, as you can see at the lower right hand quadrant, where we -- our own economists’ forecasts a more meaningful negative impact on how much of your disposable income you need to spend to cover the higher interest rates.
I know that most of the people on this call this is a very familiar narrative. I’d like to balance it because these things are clearly sources of worry, but flicking to the other page, we need also to look at the total indebtedness of the economy, if you want to have a macroeconomic assessment. And here Sweden stands out with a low government debt to GDP of -- in the area of 30%. So there are ample ability for the public sector to do simulative measures should they desire to do so.
Everything should not also be in -- compared to your income, but you can look at the household indebtedness in terms of its proportion to household assets and here we have come up lately, but we are still at a very modest level of about 20%, meaning that the household sector has 4 times as much assets as they have liabilities.
We have also seen encouraging and quite resilient signs both from the equity market and the labor market, and even if you were to have this particular negative view on Sweden, which we think needs to be balanced or moderated, we just want to remind everyone that SEB is a very international Bank.
44% of SEB’s credit exposure is in Swedish krona, and please be reminded, a lot of large corporates do not have their business in Sweden despite being a client of SEB in Sweden and 56% is actually outside the Swedish krona area. So very well diversified from a geographical perspective when it comes to cushioning asymmetric shocks that might come in different geographies at different times.
Next page is on the credit portfolio. Both the credit portfolio has exposure and lending -- actual lending and it’s been a very encouraging quarter to see that we did experience 2% growth Q-on-Q on the FX-adjusted corporate lending.
We also saw a flattish development in the mortgage and lending area, which is a slight improvement from previous where there was an uptick in June and then roughly broadly flat on the real estate based lending areas.
The next page, we will just want to remind everyone of being long-term. In the long-term perspective, our strategy is very clear that we want to gradually grow our business. We want to reinvest in SEB and we want to explore what operational leverage, which is available to us. Meaning that if income increases faster than cost, we get a very nice operating profit through the operating leverage and I will just conclude on this slide that this has been a very strong development of late.
Now I’d like to hand over to Masih to go through the financials.
Masih Yazdi
All right. Thank you, Johan, and good morning everyone on the call. So I am on slide number 10 now and we are looking briefly on the year-to-date development. You can see that the income is up 34%, very much driven by net interest income, that is up 57%. We have also seen a cost increase of about 12% year-to-date, which is in line with the full year cost target that we have communicated.
Net expected credit losses are down quite significantly from last year, but that decline is pretty much offset with increased of imposed levies and this quarter very much due to the solidarity contribution that we start to pay mid-quarter to Lithuania. Overall operating profit up 57% year-to-date compared to the first half of last year. Credit losses down to 2 basis points, and as Johan mentioned, the CET1 ratio at 19.3%.
If we move to slide number 11 and look at Q2 isolated, we can see that net interest income continues to grow at a slower pace now compared to what we have seen in the last few quarters up 5%. We see a healthy improvement of net fee and commission income of 9% in the quarter. And again operating expenses are up this quarter at 7%.
Again net expected credit losses have come down, but it is pretty much offset with imposed levies going up. So profit before ECL and imposed levies are up as much as operating profit of 4% Q-on-Q.
If we move to slide number 12 and look at the net interest income numbers. As you saw before, 57% up first half of the year compared to first half of last year and if we focus on the bridge showing the Q-on-Q development, you can see that we see a positive contribution from both corporate lending and corporate deposits, and as we have seen in the last couple of quarters, we see a negative net contribution from household lending and household deposits, where we see pressure on mortgage margins more than offsetting the improved deposit margins coming from the higher rates.
We do see an improvement of net interest income in our Baltic business of SEK200 million Q-on-Q. That should be viewed in the context of imposed levies going up as much this quarter. So the net contribution is pretty close to zero.
Then we have another contribution of SEK300 million and this is every type of lending we have that is not to the public. So it’s lending to other credit institution and also excess liquidity that we have at Central Banks. It’s only natural that that type of excess liquidity nowadays pays a yield and that yield has gone up in the last quarter given that policy rates have generally increased.
If we move to the next slide. Net fee and commission income, it’s pretty much flat year-on-year compared to first half of last year, but we have seen a healthy growth quarter-on-quarter. That is primarily driven by lending fees being above SEK1 billion this quarter, compared to just around SEK850 million in the last quarter. We see a seasonal uptick on card and payment fees, and we see an improvement of the asset management fees if you exclude performance fees, which this quarter was close to zero.
Net financial income on the next slide, 46% up year-to-date compared to last year and we have seen a small improvement in Q2 compared to Q1. It’s still at what we would say an elevated level. We have seen a level of about SEK2 billion in the last 16 quarters, 17 quarters on average. The reason it’s higher, it’s merely a positive XVA effect this quarter compared to last quarter about SEK600 million.
We continue to see good underlying business development, especially within FX and we see on -- saw an improvement in fixed income. So it is good activity from customers wanting to hedge their FX and their interest rate positions. We also see a positive contribution from treasury both in the parent bank, but as well in the Baltics.
If we move on to slide 15 and look at the capital development. We are now running at around 500 basis points of annual gross capital accumulation of the bank. So on a quarterly basis, that’s about 125 basis points, but when you deduct half of that for dividend, the contribution this quarter is 60 basis points.
Then we have had pretty significant negative FX effects that impact the balance sheet right away, the P&L effect takes some time to go through and then we have had probably or hopefully the last increase of the Swedish countercyclical buffer in the quarter that has reduced the capital buffer by 50 basis points. So, all in all, the capital buffer is down from 480 basis points in Q1 to 450 basis points in Q2.
Slide 17 some key ratios. I think it’s encouraging to see that customer deposits have come up pretty significantly, this comes both on households, as well as corporates, but the main increase here is from financial institutions.
We have done significant amount of funding both in Q1 and Q2, which has led to the net stable funding ratio coming up from 109% at year-end to 112% at this point in time and then the capital ratios we have gone through and the asset quality as well.
Then finally and just to remind everyone of our -- the financial targets we have to pay out around 50% of the annual EPS, earnings per share in dividends to have a long-term capital buffer of 100 basis points to 300 basis points above the regulatory requirements and to have a return on equity that is competitive with peers. And as Johan mentioned before, we did announce last night another share buyback program of SEK1.25 billion that will last until the Q3 results, upon which time we will communicate what we do beyond that.
With that, I think, we can open up for Q&A.
Question-and-Answer Session
Operator
[Operator Instructions] The first question is from Namita Samtani from Barclays. Please go ahead.
Namita Samtani
Hi. I have just got two questions, please. Firstly, inflation in June was around 8% and it seems pretty sticky. So what plans do you have to navigate the bank if inflation doesn’t come down to the 2% by the end of 2024 as predicted by SEB economists and Swedish policy rate have to go meaningfully above 5% to 6%? Are we at an asset quality problem at this stage and do you have a plan to mitigate cost headwinds from the inflation. And secondly are you happy with consensus share buybacks in 2024 and 2025, there are around SEK8 billion to SEK8.6 billion or are you happy with the SEK1.25 billion per quarter given your M&A bolt-on appetite? Thanks.
Johan Torgeby
Let me first start and then I will ask Masih to fill in. For planning purposes, we are, of course, using exactly the scenario that you described. So we cannot assume that inflation and interest rates will be on the path which is consensus. We also need to prepare for a more tightening of the economy should it show strong resilience and inflation not coming down.
So this is well prepared when it comes to the business side. We definitely will have a different base case, if you talk about 5%, 6% of monetary Central Bank rates when it comes to potential asset quality. That will most likely be through a recession that might be driven by less consumption and that could be more of a broader based impact.
But I wouldn’t worry too much even in that scenario from the asset quality for SEB. But clearly, the economy would have systemic quite a much higher interest rate that is currently -- that it’s currently experiencing.
We always have the typical levers at our disposal as running the bank when it comes to inflation within the bank. So should we have a cost pressure that comes because labor, inflation, wages or other type of services and goods repurchase go up, we will have to take that into account when we plan for the 2024 cost target and there are always the classic levers at our disposals to cut costs, which we have done in the past.
On the share buyback, I have no guidance to give other than that we will use share buyback as the predominant mean if we have surplus capital. It will be a decision every quarter, so we can changed -- change, right now this is the pace that we have set of SEK1.25 billion.
Masih Yazdi
Yeah. I will just add on the first point that irrespective of the inflation level, we do have central agreements in Sweden, where the last agreements, when they were written, they were done for two years and based on those agreements wage inflation will be about 3.7% next year.
And so, irrespective of the headline inflation and given that our labor cost is about 70% of our cost base and that is the sort of amount that we are believing will happen, then if inflation is higher than people expect and that could lead to some wage drift, but at least we have a ground of sort of having lower wage inflation, but that’s compared to what seems to be the case across Europe in general.
On the share buyback, I would just add that, I mean, what we can guide on is to continue to guide on what we have guided on in the past that by the end of next year we will be within our target range of 100 basis points and 300 basis points, whether the Board decides to do that through extra dividends or share buybacks and what sort of mix of those two, we don’t know. That’s going to be a decision for them at each point in time, but we continue to guide for that we are going to be within that range by the end of next year.
Namita Samtani
Thanks very much.
Operator
The next question is from Andreas Hakansson from Danske Bank. Please go ahead.
Andreas Hakansson
Thanks, and good morning, everyone. First question, on your slide 17, looking at your targets, you have this return on equity target aspiration of 15%, which of course, was set before rates really started to go up and we won’t see a big transformation in rates and are expected to be higher for longer. Would it be in this scenario where you actually step away from your tradition of having long-term plans and actually come out with an update on that target. That’s my first question. And then on the NII, the market -- I mean, I am bit frustrated with the share price performance today I must say and it seems like the market either believe that there’s an asset quality problem or that the net interest income is about to start to decline quite soon. Could you tell us in NII, if we split it into Baltic, retail and corporate, are these three areas would see the NII develop if rates continue to go up? That’s my second question. Thank you.
Masih Yazdi
Yeah. It seems like, Johan, wants me to start, so I will do that.
Johan Torgeby
Go ahead.
Masih Yazdi
Actually I forgot the first question.
Johan Torgeby
It was the return on equity aspiration. Yeah. I mean you are right in the sense that, if you want to aspire to things that are sort of more difficult to compare to what you are achieving today. So, I mean, the target is to have a return on equity that’s competitive with peers and then in the last 15 years, we have been struggling to reach 15%.
So that’s an aspiration we have set up and it was pretty much set up in an environment where we expected rates. We always plan for rates to be close to zero. That’s how we sort of dealt with the bank and the efficiencies we have taken out and all the work that’s been done in the last 10 years, 15 years were based on that we wanted to be a profitable bank, which we thought would be 15% return on equity in a zero rate environment.
Now that has changed and whether that change is permanent or temporary, we don’t know yet, but to the extent that it’s permanent, and obviously, that sort of aspiring target of 15% is not as relevant, but it is clearly relevant to be competitive with peers. So I think you should more look at the actual targets rather than aspiration. As you can see, all peers are doing better in a positive yielding environment.
On the NII and we do have a comment there in the CEO Letter that, I think, it’s important that we believe that some of the transitory elevated or transitory tailwinds we have seen on NII is behind us.
And what we are trying to say with that is that, despite the fact that we have had a few quarters now with net interest income going up, we have had some headwinds. The main headwind has been Swedish mortgage margins. They are down 70% or so.
If you assume that the end game is that they were down 100%, which is pretty significant, it still means that we have taken 70% of the pain. So we believe that a lot of the pain on the Swedish mortgage --mortgages is behind us.
Another area I mentioned is the card business, we did about a year ago, year and a half ago, have an annual net interest income in our card business close to SEK1 billion and that is close to zero today, because you typically have 45 days that are interest rate free, but our funding costs for those 45 days has gone up and then we have seen some shifts in the deposit mix as well that is behind us now.
So what we are trying to say is that when and if policy rate stop to go up and -- or you concerned that policy rates might come down and that will create a headwind, just to remind yourself of that then that will probably be offset with some tailwinds coming from the areas where we have had headwinds. So we basically trying to say that, maybe if you believe that all the headwinds is in front of that, that’s probably the wrong conclusion.
Andreas Hakansson
Okay. That’s very helpful. Thanks very much.
Operator
The next question is from Magnus Andersson from ABG. Please go ahead.
Magnus Andersson
Yes. Good morning. Just to follow-up on NII there and the dynamics of the business area levels. You mean in the -- we see that 70% of the Q-on-Q contribution is from the Baltics and in the near term since it’s fairly flat here in the other business areas, LC&I and the C&PC. Do you think that will remain the case in the near-term, i.e., fairly flat in Sweden and your international business and still buoyant in the Baltics? And related to that, you now have an ROE approaching 50% in the Baltics, does it mean that there could be a risk for further levies, bank taxes, et cetera, are there any, if you can give us an update on those discussions please?
Masih Yazdi
Yeah. Thanks, Magnus. And I don’t want to guide too much on NII in near-term. I can sort of talk about different tailwinds and headwinds. I think in the immediate short-term we did have a policy rate increase in Sweden in June. That’s a tailwind going into next quarter and the expectations are that we are going to have another rate hike in September, so that will create further sort of tailwinds going into Q4.
We do have a weaker currency on average today than we had on average in Q2 and we have an extra day in Q3 compared to Q2. And then we have had some headwinds on mortgage margins, on deposits shifts, that will probably continue at equal pace compared to what we have had in the last couple of quarters. Netting that out, it seems like we have more tailwinds than headwinds in the very short-term.
And we do have this -- you should just be aware that irrespective of what happens to net interest margins, we do have SEK200 billion worth of equity and any 25 basis points increase, that’s SEK0.5 billion improvement of NII irrespective of whether there is any potential improvement of net interest margins going forward.
On the Baltic business, you are right, the profitability is very high today and it’s very much driven by the fact that, again, we have dealt with that business, assuming that it will be in a zero rate environment for eternity basically and have run that business at very efficient levels and now we have had this very significant increase of interest rates and that has put us in the position we are in today with very healthy profitability in that business.
We already have the Lithuanian tax that has been introduced. We don’t know what’s going to happen in the other two countries. We know that in Estonia, they have already had -- have had a tax reform. So it feels like maybe that’s behind us. That’s a corporate tax increase rather than a new levy in Latvia and there are no sort of further discussions we have had or any other knowledge that we have that hasn’t been publicly communicated.
Magnus Andersson
Yeah. Okay. Thank you. And finally just on capital since, I mean, you have an almost 19% ROE in Q2 and your capital buildup is obviously very strong and you remain with the SEK5 billion annualized buyback pace. So, first of all, I guess, the first realistic point in time, we could get an extra dividend is in conjunction with the Q4 report if that’s a fair assumption? And also, I think, in conjunction with the Q1 report, you talked about any potential ramp up in the share buyback pace would definitely not come before Q4, is that still valid?
Masih Yazdi
Well, I think, on your first assumption that seems fair and that’s when the Board looks at the dividend for 2023, then there will probably be a discussion on the -- both the ordinary dividend and whether they should do anything extraordinary.
In terms of share buybacks, we are now using the second half of the last mandates we have from the FSA to buy back shares worth SEK1.25 billion during Q3. We will now, obviously, have -- we have, probably, as you know, we have an application with the FSA to do something beyond Q3 and then it’s up to the Board to decide on to what extent to use that mandates and at what pace to do share buybacks beyond Q3. So everything -- I mean all we communicated so far is what we will do until the Q3 report and there’s going to be a live discussion on what we do post the Q3 results.
Johan Torgeby
And I completely agree with, Masih, but I just want to point out, there are no limitations for the Board to propose an EGM for a dividend between September and December. I mean, now it’s going to be the Q2 and summer holidays, but just you know, even though I agree with the more likely scenario.
Magnus Andersson
Yeah. Okay. Thank you.
Operator
The next question is from Sofie Peterzens from JPMorgan. Please go ahead.
Sofie Peterzens
Yes. Hi. Here is Sofie from JPMorgan. I note that in your report, you mentioned that some of the fee -- quarter-on-quarter increase in the fee income comes from the derivatives income and secondary market, but then you also write that it was mainly driven by accrual effects. So I was just wondering if you could there kind of elaborate on this? And then my second question would be on the transaction deposit accounts. I saw that Danske increased their transaction deposit accounts this morning to 50 basis points in Sweden. What’s your view on this? And then last question would be, could you make any comments if you have seen any covenant breaches on your real estate exposures this quarter and also a few weeks ago, I think, you were in the local or in Bloomberg saying there is blood on the streets in Sweden, but not for SEB thus far, with the blood on the streets, if you could just elaborate and clarify how you see that the real estate market and why it’s not a problem for SEB or other banks? Thank you.
Masih Yazdi
Okay. Thanks, Sofie. I can start. So on the fee income side. Yeah. There have been some accrual effects. I think both when it comes to fees, as well as costs, you should see -- look at Q1 and Q2 combined. And so we have these kind of accrual effects, there are invoices and there are income or expenses taking sort of -- taken beyond a quarter end or prior to a quarter end and the way we view it is that, fee income probably in Q1 was a bit lower than the underlying activity and in Q2 is a bit higher, but combined Q1 and Q2 is sort of in line with the invoicing we have done at the activity level.
And the same goes for costs, we had too low costs in Q1, but too high fee expenses and that’s been reversed in Q2. So the increase of cost quarter-on-quarter is probably a bit exaggerated and increase of net fee income quarter-on-quarter is a bit exaggerated, but overall, it’s in line with what should be.
This transaction deposit accounts and what we have communicated, so it’s 25 basis points [Technical Difficulty] SEK100,000. We have about SEK60 billion unreserved accounts and up to SEK100,000 is about 20% of that, which is where we are paying in transaction accounts from about SEK1 billion of deposit, so it’s a fairly marginal amount.
And when it comes to transaction, in general, one should be aware that they are -- there are very high cost related to offering transaction accounts, you have very high KYC costs related to it and you have very high infrastructure payment cost related to it.
And that’s one of the main reasons or the two main reasons why those kind of accounts typically don’t pay a high interest rate, because there are large costs associated with it on the cost line and that’s, obviously, the main reason why you only have the large banks offering transaction accounts otherwise other banks would do it as well.
We have no plans of changing what we are offering today and we will, obviously, follow competition on it and if competition goes in a certain direction that sort of makes us or what changes our view on that and we will obviously adapt accordingly.
And on the Reuters article, was it, and yeah, it was just a reference, it was a question from the reporter that, what he actually said that, is there blood on the street, I think, he was referring to, is the real estate market in Sweden struggling. And I was just confirming the fact that, it is struggling obviously, because rates have gone up very quickly and you have seen equity prices come down.
The point I was trying to make is that -- that -- that’s not the same thing as bank losing money on real estate exposure. It’s very important to do -- make that differentiation between how much you have lost as an equity investor and how much you might lose as a lender.
Johan Torgeby
And on the covenant breaches, this is, of course, slightly technical, but I would argue, there has been no covenant breaches in the quarter. However, there has been renegotiations or waivers. So before you have a breach, this is, of course, the point of the covenant is that you are contractually obliged to come and sit down with the bank and we can assess the situation and before we have a problem try to cure it.
You can also see in one of the slides on the appendix exactly this phenomenon, which is on page 19 where we have renegotiation of terms and conditions on our commercial real estate, which have shown a little bit of an uptick.
Sofie Peterzens
So just to clarify, around 19% of your commercial real estate loans have been kind of restructured or refinanced or kind of rescheduled in one way or another?
Johan Torgeby
I wouldn’t say refinanced or rescheduled, it’s more that you will have a waiver. So you can allow for the company to continue despite we might have a contractual rights to call on the assets, we won’t use it and it’s typically around the interest cover ratio.
So the amount of operating profit right now needs to be several times whatever interest cost you have, that typically the first covenant and that has then been revised or you wave it, so it’s a -- it’s fine not to be that much about it for the quarter or the year.
Sofie Peterzens
Okay. That’s clear. Thank you.
Operator
The next question is from Nicolas McBeath from DNB. Please go ahead.
Nicolas McBeath
Thank you. So first question on asset quality. So if you could comment on how you think about normalized loan losses given the current composition of your balance sheet and I think consensus is predicting loan losses of around SEK3 billion for next year, which is 5 times your annualized loan loss pace looking at the first half of 2023. So given your model overlay, and yeah, I think, it was now SEK2.6 billion. What kind of scenario do you think would be required for such loan losses to materialize in 2024?
Masih Yazdi
Yeah. I can start and see whether Johan wants to fill in. Thanks, Nicolas, for that question. Yeah. You are right, I mean, we are running at 2 basis points in the first half of the year and that’s despite the fact that we have increased the portfolio overlays. I think we started at about SEK2 billion this year and then we are at SEK2.6 billion.
If you -- and I think -- I mean, we don’t know how macro is going to develop, but we would just assume that it’s going to be in line with how our economists forecast it’s going to develop, and then, I guess, it’s unlikely that you will see a massive increase of loan losses this year. Obviously, we are trying to be conservative and we took another SEK300 million of reserves against any potential deterioration of the CRE portfolio and that’s a forward-looking estimates of what potential expected losses, we could have assuming that asset values continue to go down quite significantly in the next 12 months.
I can’t guide really on where we are going to land, but I think it’s important to say that, if there is deterioration in asset quality next year, we need to have an underlying loan loss level of about SEK4.5 billion, SEK5 billion, if you assume that we use the reserves we built up the portfolio overlays then that’s still going to sort of land at around SEK2.5 billion on a net basis, which is pretty much sort of the long-term average we have had in terms of basis points, so that would be sort of a normalized level. So, I guess, there is a -- there needs to be a significant deterioration of asset quality before we come up to any elevated levels of loan losses.
Johan Torgeby
And if I may Nicolas just saying that we have this quarter as every quarter done our utmost to assess the expected credit loss level going forward. We then, of course, compare that with whatever reserves we have done on each single relationship that could have a positive probability of defaulting plus an overlay for security.
Now that is different from saying the following statement. We don’t know what’s going to happen in 2024. But what we know today with everything we model today with the assumptions, there are no further loan loss level.
So you need to have a much worse situation that we anticipate for this not to be an adequate reserve level, which is very significant to the tone of SEK5 billion or even more as Masih mentioned.
Nicolas McBeath
Okay. And then if I may just follow-up a bit on asset quality and CRE. So it seems like commercial real estate is not really keeping you awake at night and I agree this does not seem to be something that warrants elevated concern at this point, but still seems like you prefer to be cautious looking at your capital planning and your other modest buyback pace. So what do you think is actually the biggest current threat to your financial outlook that you are monitoring the closest at this point?
Masih Yazdi
So I didn’t catch the last part of your question, Nicolas.
Nicolas McBeath
Yeah. So what do you think is actually the biggest threat to your financial outlook and the kind of risk that you are monitoring the closest at this point?
Masih Yazdi
What -- if I answer the question, honestly, it’s more sort of internal stuff. We work on the strategy we have and try to make sure that we reach the targets we have set for 2030. It has lot to do with investing in the right stuff, doing the tech developments we need to do.
It’s very much -- very little related to cyclical changes in macro. We believe that we have the financial strength to be able to cope with almost any macro scenario, at least we have a better relative strength than most banks out there. We have a better capital position. We have SEK1,200 billion of a high liquid asset.
So we can cope with cyclical variations in macro and our main focus is to develop the operations, and obviously, we have the Board on our backs wanting us to reach the strategic targets we have set and to be honest that’s what sort of occupies our minds and what we might lose sleep on at night.
Johan Torgeby
And if I just fill in, the macro downside scenario is a more broad-based recession, which is hurting the economy and it’s not commercial real estate, which has collateral. There are other companies that do borrow money with less of a collateral, let’s say, but for that to be spread. This is unlikely to happen even at the very high -- higher interest rates that we are assuming could happen, but it is likely.
The other one is when rates go up this much this quickly, the economy tends to become accident prone. So that’s just a kind of caveat I want to put in there. It’s very difficult to foresee like the bank scare, we had among regional banks in the U.S. and the follow-ons in Europe, these things tend to happen when you have dramatic shifts in the economy and all these things cater for caution.
But with that said, we have done our utmost every quarter. We have been at this now for year and a half since the Ukraine started and this has been very, very well vetted by us, by our accounts [ph], but also by regulators who are looking into exactly how you reserve and what you have done and that prudency is surrounding these numbers.
Nicolas McBeath
Okay. Thanks.
Operator
The next question is from Rickard Strand from Nordea. Please go ahead.
Rickard Strand
Hi and good morning. Starting off with the question on the NII for your LC&I division, which continued up in Q2 versus Q1 by around 4% and still, as I recall it, you talked about the NII being temporarily elevated by around SEK300 million in Q1. Firstly, if you could comment on sort of how you see the sustainability in the Q2 NII and also if you could comment on the underlying NIM trends in the LC&I division given that we both have the bond-to-bank trend, but we also have potentially some pressure on from falling supply of deposits, et cetera, starting there. Thanks.
Masih Yazdi
Okay. Thanks, Rickard. I think the sustainability of the NII level in Q2 is good. The headwinds or the elevated levels we had in Q1 has pretty much corrected itself. There was an elevated level of NII coming mainly from the fixed income business and that’s come down during the quarter. So this number is sort of more an underlying correct number.
We do have some FX tailwinds in LC&FI, most of the lending we do in that division is not in Swedish krona. So you should be aware of that. So if the Swedish krona continues to weaken, you will have some tailwinds from that. We did have some lending growth in the quarter. Obviously that hasn’t had a full effect in the quarter. So that’s going to come in the coming quarter.
I think what’s different in LC&FI compare to if you take the C&PC division is that, on the lending side, all lending is connected to an interbank rate. So you have an automatic repricing of the lending side. So you don’t see the pressure there. We have seen flat margins within LC&FI for last few quarters, but we have seen flat margins with the exposure improving in quality. On a risk-adjusted basis, we have seen improving margins under our credit business. So that’s been good to see.
Rickard Strand
And just a follow-up there, on the deposit trend you are seeing, do you see that the current quantitative tightening from Central Banks is having an impact on sort of the profitable deposits you have or is it not -- has it not come into play yet?
Masih Yazdi
Well, in some tight scenario really it’s so -- and that we have seen quantitative tightening that has other impact. And at the same time, you should be aware that the corporate sector in general is having very good profits, you see record margins.
So obviously that ends up at -- as a deposit and since we are the largest -- large corporate bank and we benefit from the higher profits that the corporate sector in general have. So that’s offsetting probably some of the quantitative tightening affects you have seen in the market.
Well, I mean, it’s difficult to estimate how this will go. We know that the Central Bank here is ramping up quantitative tightening slightly from SEK3.5 billion to SEK5 billion, whether that leads to a more negative deposit development bank going forward. We will have to wait and see.
But we do, I mean, in the long-term, you have seen deposits growing faster than what they would have done had QE not happened. And then when in a quantitative tightening world you should expect deposits to grow slower than what it has done in last few years.
So we are prepared for that and that’s one of the reasons we have done very large amounts of long-term funding in the first half of the year, just to prepare for any potential negative effects on the deposit side.
And I think that’s just encouraging to see that we have done more than the record, we had in the past in terms of funding in the first half of the year compared to what we have done in the full year any time before and we have been able to do that with good spreads and good margins. So that’s been encouraging to see.
Rickard Strand
Thanks.
Operator
The next question is from Martin Leitgeb from Goldman Sachs. Please go ahead.
Martin Leitgeb
Yes. Good morning. Thank you for taking my question. I just had two follow-up questions please with regards to NII and NII progression just on the back of earlier comments. And firstly, I was just wondering, looking at your deposit progression both in terms of quantum and migration. I was just wondering if you could add a little bit of color on what you are seeing in Sweden and in the Baltics, respectively. And I am just trying to reconcile some of the language in terms of NII headwinds be behind you on the other hand, it feels like and remuneration on transaction account is picking up earlier despite compared to I believe 2007, 2008 when lease rates were around SEK475 million I believe. Secondly, I was wondering with regards to the mortgage headwinds and the comments made on the mortgage headwinds. And I think previously you indicated how much headwind you would expect from lower mortgage pricing in terms of NII progression, I was just wondering if you could update us? And secondly relating to mortgage pricing, is it still profitable from a return on equity perspective to do mortgages at this level, so is there still potentially downside potential for pricing from your perspective? Thank you.
Johan Torgeby
Okay. Thanks, Martin. I will start. We have seen similar trends on the deposit side as we have seen in the last couple of quarters. On household you see the shift of money going from transaction account to saving counts and from saving counts to term deposits. There is no real change in that. I think it’s probably at the same pace as we have seen in Q1 and that will probably continue for some time as people adjust to the higher yield environment.
When that stops? It’s difficult to know and we have a competitive offering, I think, on all different types of accounts today. So we are happy with that offering and we have no plans to change that, but obviously we will follow competition.
And on the mortgage side and the headwinds, so what I have said before is that, we have seen -- if you assume that mortgage margins go down to zero potentially, which I think is a harsh assumption, but if you do assume that, then we have taken 70% of the headwinds already. So, yeah, most of that is behind us.
And obviously, mortgages today are not profitable as a sort of standalone product. We see mortgages and the relationships we have with households through the cycle. We see them long-term. We have had sort of episodes in the past where mortgages have been profitable. Now they are not.
But we want to keep the customers. We do other business with them. They do have their deposits with us as well. They do their investments with us as well. So, therefore, we can look through episodes in the cycle where mortgages aren’t profitable as a standalone product if we value the customer and if the customer values us.
But it’s, obviously, on a product basis not a sustainable level, given that you do take some credit risk when you grab the mortgage and you should be paid for that credit risk over time. So, we do expect this to correct itself at some point when there’s a better balance between supply and demand of mortgages.
Currently, there’s low demand and there’s been a lot of supply coming out, a lot of providers of mortgage lending in the last 10 years. I think some of the smaller ones are probably struggling today with the low margins that you have on that product, because they typically have only that product and if you only have that product, you are not making a profit today, and obviously, that should correct itself over time.
You should see supply come down, and then, hopefully, when the market has recovered, you should see demand go up. You can have a better balance and then the pricing of that product would be at a fair level.
Martin Leitgeb
Thank you. Could I just follow-up on the Baltics, one more question. I was just wondering in terms of NII and NIM progression in the Baltics, obviously, the competitive element is very different and then the starting position is very different in the Baltics. Are there any upcoming headwinds in terms of NII progression you are looking at or could there be a scenario that NII just stabilizes at a much higher level compared to history given the different rate environment?
Masih Yazdi
Yeah. I mean there are two big differences between the Baltics and the Swedish business. The first one is that we have more deposits than lending in the Baltics and we placed that excess liquidity in the Central Bank and get a yield on that. That’s very different compared to Sweden where you have clearly more lending in the deposits.
The second difference is mortgage pricing in the Baltics. It’s based on interbank rates. So when rates go up, you have an automatic increase of mortgage rates, whereas in the Swedish market you have a decoupling between the pricing and our funding cost. There’s a list price and you have to actively change that list price and the market hasn’t done that.
So those two differences lead to this more positive development of the net interest margin and the net interest income in the Baltics compared to the Swedish market and there is nothing sort of suggesting that’s going to change anytime soon. We probably will have that excess liquidity and the pricing models or mortgages in Baltics are unlikely to change anytime soon, at least we don’t foresee that.
Martin Leitgeb
Very clear. Thank you very much.
Operator
The next question is from Geoff Dawes from SG. Please go ahead.
Geoff Dawes
Yeah. Good morning, everyone. This is Geoff Dawes here from SocGen. And just a couple of questions quite quick. The first one on, sorry, again, but net interest income. And most of the comments you have kind of made on the call, if I sum them up, it actually feels quite positive on NII momentum at the Group level for the next few quarters. But if I read the report, the comments felt a little bit negative on NII momentum. So can you just kind of tell us which it is and why there’s discrepancy? And second of all, on currency impacts, you have obviously increased the cost guidance related to the FX increase. Can we assume that the cost income ratio for non-krona operations is roughly the same, so if you add SEK0.5 billion on your cost guidance, we can effectively add SEK1 billion or so on the revenue guidance at the same time, there’s no kind of major discrepancy there? And that’s it. Thank you very much.
Masih Yazdi
Thanks, Geoff. When it comes to NII, I don’t know what comments you are referring to in terms of being a discrepancy and we believe that in the short-term, there is likely to be more tailwinds than headwinds on net interest income, mainly because there have been policy rate increases in June and there are likely to be a couple of more, at least one more in the coming months, and as long as you have that, you are probably to have more tailwinds and headwinds on net interest income. So that’s what we want to say about that.
On the cost guidance, it’s -- we have a lower cost income ratio in the non-SEK business. The cost income ratio on the Group level, you can see it’s 0.34. In the non-SEK business, it’s about 0.25. So we actually do benefit from the weakening krona. We have a higher profitability in our non-SEK business and we have a lower cost income ratio in the non-SEK business.
Geoff Dawes
Okay. That’s all very clear. Yeah. On the report comments, it’s just the transitory strength is behind us is, I think, the specific phrasing that sticks in my mind, now sticks in some other people’s minds as well?
Masih Yazdi
Yeah. Yeah. I understand that now. What we are trying -- that was actually a positive comment in the sense that, to the extent that there are headwinds on net interest income, some of those headwinds are behind us.
You shouldn’t just look at the improved net interest income over the last few quarters and assume that we have only had tailwinds. We have also had some headwinds, especially on Swedish mortgages, for example, where we have taken a large decrease of the margins in the last few quarters and there shouldn’t be that much left to go in the next few quarters.
So we are trying to say that the transitory elevated net interest income, you might have seen the last couple of quarters is behind us. There’s less of that in the current numbers. Was that more clear? I hope it was.
Geoff Dawes
Yeah. I think so. Yeah. The positive momentum is the -- I think the main -- the main way to put it. That’s what is helpful to me.
Johan Torgeby
Let me try it, because I think this is an important point. To the extent last quarter, we were saying be careful with the elevated level of NII as things will not necessarily be there in the long-term. We say there’s less of that. We are starting to land with a lot of the things that needs to happen, clients moving over to term accounts, repricing the mortgage book on the floating rate side and the headwinds. So it’s becoming more a new normal. Is that fair, Masih?
Masih Yazdi
Perfect. Yeah.
Geoff Dawes
Great. Thank you. Thank you for that.
Operator
The next question is from Piers Brown from HSBC. Please go ahead.
Piers Brown
Yeah. Good morning. I have just got a question on some of the mix changes within the lending portfolio between the various stages and particularly the increase in the Stage 2 balances. I think they are up about 7% this quarter. So if you could just talk to that increase, if there’s anything specific that’s driving that? And then related to that, I don’t know if you can sort of address the linkage to risk weighted assets and if there is any. So whether you are starting to see any inflation on the RWA front from negative ratings migration and some of these mix shifts within the stages of the loan book? Thanks.
Masih Yazdi
All right. Thanks, Piers. Yeah. You are correct, there’s been an increase in Stage 2 and it’s mostly driven by FX, but it’s also one or two counterparties that have been migrating from Stage 1 or Stage 2. But it’s just be aware that the krona has weakened 4% or 5% during the quarter. So you should have that in mind.
On the migration side, yeah, you can see in the table we have on risk exposure amount that asset quality as a standalone. It should increase, I think, our risk exposure amount by SEK4 billion in the quarter. So there’s been a small deterioration, so some net negative migration in the portfolio.
Again, we have said this in the past, when you have an economic downturn, you should be seeing net negative migration. So, I think, that’s a fair assumption to assume that going forward, the average risk weights should increase somewhat.
We have said that in the past as well, in the pandemic, we said the same thing, it didn’t happen, because we wrote new business at better risk weights than the average back book risk base of the bank. But I think, again, this time, I will say that, when the economy deteriorates, you should see negative migrations.
Piers Brown
Okay. Could I just ask a clarification on that, so the negative migrations we are seeing, which are driving the RWA. I mean, they would be coming from other areas that aren’t CRE. So that would be then just the normal corporate book, because I am just thinking, obviously, the CRE, the floor is a pillar two requirement. So if you had increased, I guess, probably…
Masih Yazdi
Yeah.
Piers Brown
… other most and behold assumptions on that, it wouldn’t actually impact the RWA, why…
Masih Yazdi
Yeah. If it -- within CRE, if then you would see the risk exposure amount to go up because of migration. But then the pillar two requirements would simultaneously go down. So there will be a net effect of zero. If it’s outside of CRE then, obviously, that migration only increases the risk exposure amount and nothing happens to pillar two. But you are right, I mean, if it’s within CRE, there’s a net effect of zero, because you reduce the pillar two add-on.
Piers Brown
Yeah. Okay. That’s clear. Thank you very much.
Operator
The next question is from Riccardo Rovere from Mediobanca. Please go ahead.
Riccardo Rovere
Yeah. Thanks. Good morning, everybody. Thanks for taking my question. The first one is, if I go on your Factbook on page nine with the famous table where you show rates. If I look at deposits, the line deposits and borrowing from the public, you show the cost of deposits was 266 basis points in Q2 and it was basically zero before the start of the tightening cycle in Q1 2022. So there is a difference of, let’s say, 265 basis points to make it simple and rate in Sweden are more or less the same in Europe. Your area has gone up by 350 basis points. I admit I take out the last 25 basis points in Sweden that was effective in July. If I take 265 basis points and I divide it by 350%, I get to a deposit beta of more than 75%. So the question here is, is the right way of seeing things, I don’t really see why it should not pay and if this is the right way of seeing things, if you are running, if SEB is running at 75 deposit beta and then we can complicate things with transaction accounts, the Baltics and Sweden, how higher can you go when it is already at 75% plus? This is the first question. The second question I have is, on the enormous prefunding that you have done in a semester. It’s more than SEK200 billion in debt securities, which is mostly commercial papers, but not just commercial papers and this looks like to be, can I say parked in caption Central Bank accounts, where I would imagine you are making a very thin spread. So what’s the logic of such enormous prefunding? Do you expect the loan growth, especially in the corporate side to continue as it has been in the first semester maybe fueled by sustainability financing and so on? So just want to understand whether -- what’s the logic behind such large prefunding? And the third question I have is, on trading revenues, your guidance was couple of billions per quarter. The couple of billions per quarter is becoming a sort of rarity. It was SEK2.4 billion, now it’s SEK2.6 billion. So I was just wondering, aside from market movement and I understand the conditions in the market have been particularly favorable in this quarter. But in general terms, a number of counterparties which -- with which you deal, are they going up and the average size of the transactions of any ticket, is it going up? Just to may -- just to better understand if there is -- aside from favorable conditions, if there is a kind of growing level of activity behind the SEK2.4 billion in Q1 and now SEK2.6 billion is in the trading line? Thanks.
Masih Yazdi
Okay. Thanks, Riccardo. I will -- I think I will take the two first questions and I will leave the last one to Johan. On your deposit beta calculation, I can’t fully verify it, but I don’t think you are far off. It is true that deposit beta in Sweden has been high. You can see that on all accounts.
So, yeah, I mean, deposit rates have increased I think, if I look at the different statistics, more in Sweden compared to other countries and we have competitive offerings on different type of deposits.
So, yeah, maybe you have seen and that’s one of the reasons we see that some of the elevated transitory effects are behind us, because we have seen much of this move already. I think what people sort of forget sometimes is the fact that we have more than SEK200 billion of equity.
So if nothing had happened to net interest margins, given the interest rate increase that we have had, net interest income would still have been SEK8 billion or so higher only because of the fact that we have free cash flows in terms of our equity that we use in our lending business and so that’s a tailwind we have had and is unlikely to go away in a higher rate environment.
On the funding side, I mean, yes, we have done a lot of prefunding. As I said, it’s driven by the fact that we are cautious going into second half of this year and also next year. We don’t know exactly what’s hopping to happen with quantitative tightening and that -- what that’s going to lead to.
What I think is important is not to exaggerate the cost of doing this prefunding. I mean, we have done all this and you still see net interest income for the bank to go up. The cost for us to do prefunding is basically 40 basis points, 50 basis points. So we pay the investors that buy our bonds about 40 basis points, 50 basis points more than we get paid when we place this excess liquidity at the Central Bank, for example.
So that’s the cost we should be looking at and right now we think it’s worthwhile to take that cost to be conservative and cautious going forward, and obviously, we will not do the same amount of funding in the second half of the year as we have done in the first half. So this should taper off quite a bit in the second half.
Johan Torgeby
And then on the NFI reasoning, I would be very cautious in assuming that we have increased the number of clients. This is predominantly asset managers, financial institutions and other counterparties we have in our markets business and to some extent large corporate treasuries. However, volumes have gone up and velocity has gone up.
So if you look at -- has there been more or less commerce around this area? There has been more. We did point out a quarter or two ago, the fixed income business. We also had a very strong contribution from the commodities business and FX.
So all these things are, of course, for a hopeful banker, something we have been struggling with for over a decade, I would say, 15 years. FX have done pretty good, but all the others have had a very strong headwind. And right now, they have tailwinds, and if we are lucky, the next decade, this will be great commercial businesses to be in.
And as you know, with the new capital requirements over the last decade, it’s been more costly to run market business and generate NFI, and the ones who have invested in it like us are, of course, here now to serve our customers in this new environment.
Riccardo Rovere
Thanks. Thanks a lot for your comments. If I may just a quick follow-up back on the prefunding, has the prefunding being executed mostly at the beginning of the quarter or at the end of the quarter or equally split throughout the three months?
Masih Yazdi
It’s been perfectly equally split between the different months in the quarter.
Riccardo Rovere
Thanks.
Operator
[Operator Instructions] Gentlemen there are no more questions registered at this time.
Johan Torgeby
Thank you very much. Then we are happy to conclude this call and we from SEB which -- wish you all a very pleasant summer while this reporting circus is over. Thank you very much.
Operator
Ladies and gentlemen, thank you for joining. The conference is now over. You may disconnect your telephones.
For further details see:
Skandinaviska Enskilda Banken AB (publ) (SKVKY) Q2 2023 Earnings Call Transcript