European Banks' Equity Cushions Remain Thin

We've spent much of the past two years warning investors that relatively high and growing regulatory capital ratios obscure European banks' underlying thin cushions of tangible common equity. Little has changed on this front.

European banks' Core Tier 1 ratios continue to compare favorably with those of U.S. banks and are generally at or near the 10% level we see as a market-imposed target. Moreover, these ratios improved by about 150 basis points over the 21 months through Sept. 30--the average Core Tier 1 ratio among major European banks improved to 12.3% as of Sept. 30 from 10.8% at the end of 2010. Over this same period, the big four U.S. bank's common equity ratios improved only slightly more: They averaged 11.1% at the end of September compared with 9.4% at the end of 2010.

However, European banks' ratios of tangible common equity/tangible assets, after adjusting for differences between U.S. GAAP and IFRS accounting standards, vary significantly and have improved very little over time. On average, the TCE ratios of major European banks, as we calculate them, have improved only 30 basis points since the end of 2010. We have seen material improvement at only a few companies--Commerzbank's (CBK) TCE ratio has improved 255 basis points to 3.9% and UBS' (UBS) has improved 94 basis points to 5.0%, but Credit Agricole's (ACA) TCE ratio actually fell 18 basis points to 1.7%, still by far the worst among the European banks we cover.

In large part, the misleading combination of high regulatory ratios and low TCE ratios is a product of the way that Basel capital rules measure risk--the banks' hefty portfolios of sovereign debt, for example, are viewed as riskless and therefore the banks are required to hold no capital against them. Since the end of 2010, European banks have shifted further away from assets carrying heavy risk weightings into assets with lower ratings. Moreover, many banks have further reduced their risk-weighted assets, as measured by the Basel rules, by changing their models that measure risk--often without altering the underlying risks in any way. While we accept the notion of risk rating generally--clearly a delinquent credit card loan is more likely to experience losses than a U.S. Treasury bond, and more capital should be held against the riskier asset--we argue that the two measures should be viewed in tandem. In our opinion, no backward-looking system, such as regulatory risk ratings, can adequately capture the true risk inherent in the underlying probability distribution.

Capital Levels May Provide a Roadmap to Future Dividend Payouts
While we think that the current low levels of tangible common equity at many European banks will mean low or no dividend payouts for many years, we think European bank investors seeking higher yields or a catalyst for stock price appreciation should look toward banks that meet our 5% TCE threshold, or are likely to do so in the near future, but are still paying crisis-level dividends.

In particular, we point to UBS, which already meets our 5% TCE target but is currently yielding just 0.7%. In fact, management has already indicated that the bank is likely to pay a material dividend as soon as 2014 or 2015. We also see significant potential for higher dividend payouts at Royal Bank of Scotland (RBS) and BNP Paribas (BNP). On the opposite side of the spectrum, we think investors in Credit Agricole, Credit Suisse (CS), and Deutsche Bank (DB) are unlikely to see attractive dividend payouts until at least 2017.

European Bank Prices Currently Provide Little Margin of Safety
Market prices for European banks have risen substantially since our last update, and major European banks are now trading at 105% of our fair value estimates and 105% of tangible book value, on average. In contrast, the big four U.S. banks, which are far less exposed to further turmoil in the eurozone, trade at 97% of our fair value estimates and only a slightly higher premium to tangible book value, 111%. We currently see the greatest value in some of our highest-quality names,  Julius Baer (BAER) and  Wells Fargo (WFC), which offer an average 16% discount to our fair value estimates and little risk of capital destruction. We think these offer far more value than similar but more highly leveraged European banks like Deutsche Bank, which is trading at a 12% discount to our fair value estimate and a 13% discount to tangible book value.