More Pain Ahead For European Banks

By Matt Cavallaro | August 19, 2011 AAA

It may not be the credit crisis of 2008, but this market does feel a little like deja vu. This time, Europe is in the driver's seat. S&P's downgrade of the U.S. long-term debt rating served to shine a brighter light on the European financial situation, and the global debt crisis is casting a dark shadow over big foreign banks. (For more on the European Banks, check out Markets Lower On Fears Over Exposure To European Banking Sector.)

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Transparency Lacking, Old Debt Troubles Remain
Opacity in the European banking system is a critical concern right now. Back in 2008, there was so much unknown surrounding a seemingly endless chasm of loan losses within the shadow banking system. That lack of transparency played a major role in panic selling during the financial crisis. Europe is in danger of repeating history. Less than full disclosure is adding to the risk premium for Euro banks. We just don't know exactly how much bad sovereign debt these banks are holding. Reflecting this uncertainty, credit default swap spreads for investment grade European companies are trading at their highest levels in over two years.

Banks with less exposure to bad sovereign debt that are based in nations with structural surpluses, like the Royal Bank of Canada (NYSE:RY), are less risky. Yet the Royal Bank of Canada hasn't escaped debt woes. Struck by waves of commercial and real estate loan defaults over the past few years, the bank recently sold its U.S.-based operations, known as RBC Bank, to PNC Financial (NYSE:PNC), realizing a C$1.6 billion loss. There's no escaping bad debt.

PIIGS Are Still Here
Clearly, the remnants of the financial crisis continue to take a heavy toll. In Europe, the economies of Greece, Ireland, and Portugal have not stopped shrinking. Lower tax revenues have led to higher debt-to-GDP ratios in many countries. Eurozone banks will continue to be weighed down by structural weakness in debt-laden nations - particularly Portugal, Ireland, Italy, Greece and Spain (PIIGS) - for the near future. Even France, a nation rich with reserves and the political will to address structural deficits, is a potential credit risk because of their own revenue shortfall and significant domestic bank holdings of Greek and Italian debt. French banks are paying the price for this perceived risk (deserved or not). Despite confirmation by S&P of France's AAA- rating, and being on pace to meet solvency requirements by the end of 2013, French bank Societe Generale (OTCBB: SCGLY) is a very high beta play. The same is true of Paris-based banking giant Credit Agricole S.A.

Does Europe have the resources to deal with the debt problem? A Bloomberg estimate puts the market-to-tangible equity ratio of 31 European banks at just under 70%. Using this ratio, a massive capital base of $195.1 billion is needed to sufficiently cover potential losses. Of more concern is the European Central Bank's relatively small capital base (about ¬10 billion) which is significantly lower than what the Fed started out with in 2008 when the financial crisis struck.

An announcement on August 10 by Commerzbank (OTCBB:CRZBY), Germany's second-largest lender, underlines the impact that bad debt is having. $1.07 billion in Greek debt impairments wiped out Commerzbank's second quarter profit. Of course, much of Commerzbank's loan loss provisions have been baked into the shares already. In fact, Germany appears be the lone "safe haven" in Europe. The German economy should expand roughly 3% in 2011. German banks, like Deutsche Bank AG (NYSE:DB), may experience smaller valuation corrections. Deutsche Bank does have significant exposure to heavily indebted nations, like Italy and Spain whose borrowing costs have recently spiked, yet the strength of the German financial system may prevent steeper losses.

The Bottom Line
Even considering Germany's strength, the European banking sector is an extremely risky play for retail investors. If and when deeply indebted Eurozone nations default, the ECB's lower capital base means there are fewer bullets to stem any crisis with. A ban on short selling certain stocks in France, Italy, Spain and Belgium is confirmation that regulators believe the European banking system is fragile. Investors with low risk appetite should avoid the European banking sector at all costs. (For more on the reduction of short selling, check out Europe Bans Short Selling.)

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