We put banks through a series of stress tests and find some opportunities for risk-tolerant investors.
European banks are reporting strong regulatory capital ratios, yet many are trading at around half of their tangible book values, implying that markets think that heavy losses and dilutive capital raises lie ahead. We think that all European banks will face choppy profitability and volatile trading until a solution to the euro problem is found but that some banks are in a better position to weather the storm than are others.
For investors drooling over the discounts being offered on Europe’s banks, we looked at which banks appear to be bargains and which might be value traps. To do this, we put the European banks Morningstar covers (Exhibit 1) through a series of tests to measure which ones have the sufficient tangible—not just regulatory—capital and adequate access to high-quality funding.
Looks Can Be Deceiving
Most major European banks’ capital levels look fine when measured by regulatory ratios. Many are at or near 10%, the level that we see the market targeting, and the December European Banking Authority capital tests showed that the 17 major European Union banks that Morningstar covers need only EUR 42 billion of additional capital. This amount is small enough that most major banks outside of Italy and Spain will be able to cover the shortfall with retained earnings. Yet the regulatory ratios disguise the true variation in European banks’ capital levels.
Moreover, all of banks meet the upcoming Basel III minimums with current risk weightings. Under the new rules, which will be phased in between 2013 and 2019, banks will have to hold core capital equivalent to 7% to 9.5% of their risk-weighted assets, depending on their level of systematic importance.
In many ways, using regulatory risk weightings makes sense to measure a bank’s capital. Clearly, it is important for a bank to hold more capital against a delinquent credit-card loan than a short-term U.S. Treasury bond; the bank is much more likely to experience losses on the credit-card loan. Risk-weighted assets are a logical way of dealing with this; riskier assets are given higher weightings, and some assets that are perceived to be without risk are given 0% weightings.
However, we see two problems with risk weightings. First, as with any rules-based system, it can be right in the abstract but wrong in individual cases. Risk-weighted-assets calculations depend in large part on bond ratings, and we’ve seen many examples recently in which bond ratings turned out to be wildly inaccurate. Second, under Basel II rules (as opposed to the Basel I rules used in the United States), banks use internal models to evaluate the riskiness of some of their assets. We’re unconvinced that these internal models are able to incorporate the risk of a worse outcome than seen in the short history of modern finance.
We argue that Europe’s banks should be held to a higher standard to restore the markets’ confidence in them. Therefore, instead of relying solely on regulatory capital ratios, we prefer to measure European banks by the same yardstick we use for U.S. banks-their ratio of tangible common equity/ tangible assets (adjusted for U.S.-European accounting differences). This ratio measures a bank’s ability to take in losses before becoming insolvent.
In fact, Morningstar’s research shows that uniformly lofty regulatory capital levels in Europe are obscuring highly variable and generally inadequate bases of tangible common equity. Even after adjusting for divergent derivative accounting, many European banks are leveraged 20 to 1 or 25 to 1-far more than their U.S. peers- leaving European banks with too slim of an equity cushion to absorb losses.