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By Jeremy Glaser and Erin Davis | 11-12-2012 03:00 PM

Should You Bank on Europe?

Although European banks are trying to build a large buffer against continental turmoil, the risks are still there, according to Morningstar's Erin Davis.

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. I am here today with Erin Davis. She is our senior analyst covering European banks. We're going to see how the banks are holding up in the face of the euro crisis.

Erin, thanks for talking with me today.

Erin Davis: Hi, Jeremy, I am happy to be here.

Glaser: So let's talk a little bit about how the banks are kind of coping with the turmoil. Certainly, things seem to have calmed down a little bit from this summer, but there are still some problems out there. How are the banks doing?

Davis: Well, we are seeing the banks in general trying to build up as much of a buffer as they can against resumed turmoil. They are retaining capital as much as they can by paying out nominal, if any, dividends, and selling any noncore businesses that they can spare and find a buyer for. They are also selling their riskiest assets like troubled sovereign debt as much as they can find buyers. And we're also seeing banks cut their exposure to Greece as much as possible. The two big French banks that had Greek subsidiaries recently both sold them for a nominal EUR 1 each taking big losses on the transaction.

Glaser: So, when you look at the problems that might be facing the bank, is it kind of these big macro issues that have happened in Europe, or is it really the loan losses--the money that they lent out just isn't coming back anymore?

Davis: I think that that varies a lot by country. In stronger countries like France and Germany and even the United Kingdom, we are seeing fairly stable loan losses. In other countries like in Italy and Spain, we're seeing higher and higher loan losses, not enough that they're causing the banks to tip into the red in general, but it's getting there. And in Ireland, we're continuing to see very heavy loan losses.

And when thinking about loan losses in Europe, I think that it's important to consider the differences between international accounting standards and U.S. accounting standards. In international accounting standards, banks aren't allowed to build up as much of a cookie jar against loan losses as they are in the U.S. In the U.S. it's not uncommon to see banks holding reserves worth 300% of their nonperforming loans, but in Europe, numbers more like 40% are common. So that means that as the economy has continued to slip into recession, we're likely to see higher and higher loans losses.

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