How Risky Are European Banks Right Now?

There is no fear like fear of the unknown. And that is perhaps what investors found so unsettling about news that a European bank — whose identity hasn’t been made public — faced so much funding pressure that on Wednesday it had to borrow $500 million from the European Central Bank, its lender of last resort.

The incident stoked concerns about broader funding for the banks of Europe and particularly France. Société Générale, the second-largest French bank, led a broad and steep decline on Thursday in European shares that extended into trading sessions in the U.S. At midday the Standard & Poor’s 500 index was trading at 1,141, down 52, or 4.38 percent. Stock prices fell sharply earlier in the day, with the FTSE 100 index down 4.49 percent and the DAX down 5.82 percent.

Fears about the ability of European banks to tap adequate funding amid the worsening debt crisis on the Continent accounted for much of the declines. French banks, which have high levels of exposure to the sovereign debt of Spain, Italy, Greece, Ireland and Portugal, led the way. Société Générale shares fell 12.3 percent, and shares of Crédit Agricole were down 5.6 percent.

The cost of insuring against a default by French banks rose to record levels. SocGen credit default swaps rose 8 basis points, to 342, according to data.

Banking regulators at the Federal Reserve Bank of New York worry that the U.S. operations of European banks could be vulnerable to credit pressures at the corporate level, according to a report in the Wall Street Journal. Concerned that European banks will repatriate capital from their U.S. operations, New York Fed officials are pressing the banks to make structural changes to protect their U.S. units, the Journal said. The price of insuring U.S. bank debt rose on Thursday, and the price of U.S. bank bonds fell.

Are the concerns about European banks — and French banks in particular — grounded in reality, or is the selling based on fear? The answer is that European bank funding fears are legitimate, although equity strategists have different views on the nature of the risk. Here are two outlooks on European banks, one bullish and one underweight.

Jon Peace
Pan-European bank analyst
Nomura Securities International
Sector View: Bullish

“There are a few red flags regarding funding for European banks. But they are mostly short-term funding concerns, and we are much more concerned about long-term funding,” Peace says. “It’s the long-term senior unsecured debt market that we have our eye on. That can indicate real distress for banks. If it can’t fund independently for the longer term, that can raise real questions about its viability.”

For the moment, there are short-term funding flags, and they are subject to misinterpretation, according to Peace. One measure of bank funding — the spread between LIBOR and the overnight indexed swap rate — has widened, as it did in 2008. But three years ago the gap widened because LIBOR went up. This time it has widened because the OIS has gone down, reflecting expectations of lower interest rates. LIBOR has actually come down. The bottom line, Peace says, is that the gap doesn’t reflect higher rates, as it did in the same way it did in 2008. It also is true that banks have a tougher time borrowing in U.S. dollars, and euro-dollar basis swaps have become more expensive. But the costs are rising at the short end of the curve, not the long end. That suggests to Peace that constraints on borrowing in dollars are a shorter-term problem, at least for now.

Peace says the real key to the health of European bank funding is the longer-term market. On Wednesday, HSBC Holdings was able to sell $500 million worth of Swedish krona in three-year notes, the first longer-term European bank debt sale of that size since June, he says. Peace notes that the lack of such activity in recent months may partly reflect the fact that many European banks already have funded about 90 percent of their longer-term needs for the year.

The true test of the European banks’ funding ability — and solvency — may not come until September or October, when they will need to issue more longer-term debt, he says.

Peace contends that it could take a while for European bank shares to turn around.

大部分的担忧欧洲银行,French banks in particular, is linked to their exposure to sovereign debt. The combined debt of Greece, Ireland, Italy, Portugal and Spain is $4.8 trillion, about twice as high as subprime debt during the financial crisis. Spain and Italy can afford to service their portions of that debt as long as interest rates remain in the 5 percent range. When rates push into the 6 and 7 percent range — as they did last week, provoking an intervention by the European Central Bank — the debt becomes too expensive to service.

The ECB has been buying the debt of Italy and Spain, pushing Italy’s rate down to about 4.8 percent. But the ECB doesn’t want to continue that program forever, and there’s no guarantee that the European Financial Stability Facility will be adequately funded to take its place over the longer term. So for now European sovereign states such as Italy and Spain can’t fund themselves independently, and there’s no guarantee that the ECB or the EFSF will work out a longer-term solution. Germany and France have rejected the idea for now of issuing euro-zone-wide bonds that would replace the debt of sovereign members.

The European banks have exposure to the sovereign debt. That is the risk and the source of fear.

Until the market becomes convinced that Europe can ensure the solvency of Italy and Spain, the “apparent deep value” of European banks “offers little protection” against more declines in the market, Peace says.

Alec Young
International equity strategist
Standard & Poor’s
Sector view: Underweight

Given the risks in the overall environment, Young says, he is significantly underweight in European financials.

“The European debt crisis has been going on for a long time. It never seems to go away,” he says. European leaders such as Nicolas Sarkozy of France and Angela Merkel of Germany “don’t get it,” announcing that they would save the creation of Eurobonds as a replacement for sovereign debt only as a last resort. And they had no desire to increase the EFSF. Instead, European leaders have pushed a short-selling ban and a financial transactions tax to raise money. Young says the markets told officials that they need to resolve the crisis, and they ended up instead with solutions such as a short-selling ban that they don’t like.

“The market is saying this is a crisis,” Young says. “The time for a last resort is now.”

Until the funding issues for Italy and Spain are worked out, “there will be a lot of tension around European banks, and we would have a very cautious approach,” he says. “The smart money says this is no time to be a hero.”

Standard & Poor’s equity research suggests that the S&P 500 will rise to 1,400 over the next 12 months and perhaps back up to to 1,260 by the end of the year. But if the U.S. does enter a recession, Young says, there is a “significant downside” maybe into the 900 to 1,000 range. That isn’t his forecast, but he says it is possible.

European banks may look like a bargain. “But what looks like a bargain today might not seem like a bargain a few weeks from now,” Young says.