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.
Using the tangible common equity ratio, we found that many European banks fall woefully short of the 4% to 5% level that we see as appropriate (Exhibit 2). Deutsche Bank DBK and Credit Agricole ACA, two of the worst offenders, have ratios well under 3% by our calculations, compared with the 5.5% to 7.5% levels seen at major U.S. banks. Dexia, before it was rescued, had a ratio of only 1.2%.
While many European banks that don’t meet our expectations only need a small boost, some banks have huge shortfalls. Credit Agricole and Credit Suisse CSGN both need to more than double their tangible common equity reach a 5% tangible common equity/ tangible assets ratio, and Deutsche Bank needs to increase its ratio by 88%. While regulatory standards do not require banks to hold this much capital, if markets do, as we think they should, the resulting capital raises would likely be hugely dilutive, especially considering the banks’ depressed share prices.
Not All Funding Is Equal in Europe
Banks need stable, low-cost funding because many of their assets are illiquid. Many European banks have been dependent on short-term wholesale funding for far too long. Customer deposits are our favorite form of funding, because they are typically “sticky” and very low cost. Long-term wholesale funding can be a good, occasionally more stable substitute in markets where deposits are not sufficiently available, but many banks have, especially historically, turned instead to short-term funding as a substitute for deposits. As a result, many European banks were caught with their pants down in 2007 and 2008 when markets rapidly withdrew liquidity. While banks have worked to correct this problem, some are further along than others and, therefore, are better prepared to meet the stress associated with the sovereign debt crisis.
In two more tests, we measured customer deposit funding both as a percent of customer loans and as a percent of adjusted liabilities. We found that Julius Baer BAER, HSBC HSBA, Deutsche Bank, and Standard Chartered STAN have the best funding profiles among the large eurozone banks. All have loan/deposit ratios below 100% (meaning that all of their loans are funded by customer deposits) and deposits that make up 40% or more of their adjusted liabilities. The top four U.S. banks-Bank of America BAC, Citigroup C, JPMorgan Chase JPM, Wells Fargo WFC-also meet both of these standards. Conversely, we find that Unicredit UCG and Lloyds Banking Group LLOY remain dangerously reliant on wholesale funding to shore up their inadequate deposit bases. Both have loan/deposit ratios of more than 140%.
While the results underscore the riskiness of European banks relative to U.S. banks, they also speak to competitive issues. Julius Baer, HSBC, Deutsche Bank, and Standard Chartered-as well as Credit Suisse and UBS UBSN-all not only have sufficient deposit bases for their current loan portfolios, but also have room to grow, which we think will prove to be a competitive advantage in this environment of funding scarcity. A hefty low-cost deposit base will also provide a cost advantage as competitors pay up for pricy wholesale funding.
Finding the Healthiest European Banks
Looking at all of our metrics together
All European banks face risk from an economic slowdown, at a minimum, and most at least face some peripheral sovereign exposure, but we think that the sector has punished them fairly indiscriminately. This has created opportunities for risk-tolerant investors. Looking across our metrics, we are particularly interested in Lloyds, Royal Bank of Scotland RBS, and UBS.
Lloyds scores badly on the customer loans/ customer deposits test, with a 143% ratio, but it does much better on the other funding test. We also note that it has a 4.4% tangible common equity ratio-not quite as strong as we would like to see, but comfortably above the 4% level we see as minimally acceptable. We’re also pleased that it has relatively small exposures to sovereign debt, although it has more-substantial exposure to consumer and commercial lending in Ireland.
RBS looks even better through these lenses. Its customer loan/customer deposit ratio is only marginally above 100%, and customer deposits make up 45% of its adjusted liabilities. Most intriguing of all, its tangible common equity ratio is 5.5%, and the bank is one of the few that appears to meet U.S. standards. RBS also has minimal exposure overall to peripheral sovereign debt, but it does hold a large portfolio of troubled Irish loans.
Finally, our metrics also suggest that UBS is a good pick. Its funding metrics are all within or near our target ranges, and its tangible common equity ratio is a fairly reasonable 4.7%. This is much higher than the 2.4% that we calculate for Credit Suisse, but we think that Credit Suisse is the better operator and risk manager. UBS benefits from being a non-euro bank and has minimal exposure to peripheral Europe, although its earnings are stressed by the crisis and by the strong Swiss franc.