Europe Should Stress Over Bank Stress Tests

 |  Includes: ACA, BCS, DB, ERO, EU, EZU, FXE, IEV, LYG, RBS, VGK
by: Markos Kaminis

European banks are being asked to come clean, but the EU might not be thrilled with what the search turns up. The application of American style stress tests on European banks seems sure to uncover hidden assets, burrowed bad loans, lax and otherwise questionable lending activity, and just general trouble.

While US investors took a breather for the celebration of Independence Day, all was not at ease overseas on Monday. Ambiguity seemed to remain around the European version of bank stress testing, with investors expressing concern about how Europe plans to resolve issues with troubled banks. Institutions also worried that the tests may not go far enough to satisfy the investment community.

Questions may still remain whether Europe's banks could withstand the toughest of times (read sovereign default). However, EU Economic and Monetary Affairs Commissioner Olli Rehn said (in his usual painful stutter) full transparency would be demanded with sovereign default risk factored in. As long as the Europeans come clean and at the same time offer a plan for troubled financial institutions, there may be hope to bring the valuation gap between US and EU banks in line. The valuation difference is approximately 20% on price-to-book ratios.

However, we suspect what the Europeans turn up might just be more concerning than what we don't know now. Perhaps American style economic solutions simply will not fit Europe's shoe size, or maybe it's just time Europe change its ways. That's a sad thought though...

There remains great concern about the state of the European banking system. Europe's banks have written down or off less than half the assets of US banks (percentage basis), and there's some evidence that Spanish banks are hiding real estate loan losses on their balance sheets. This is very likely not limited to Spain though, and mark-to-make-believe is still en vogue in Europe among volatile securities, thanks to crisis implemented accounting rule changes. The EU says it will disclose the results of its stress tests by the end of July, but we have to wonder if they are still feeling okay about that after seeing the early showings.

For now, investors would like to at least see the criteria of the stress tests disclosed. This will be Europe's chance to prove to investors that it means business, and will force banks to come clean. Without signs now that EU bank results will not be fudged nor withheld, investors simply cannot embrace the idea. In the end, the EU might be better off not looking at all anyway.

European bank shares came under pressure Monday due to stress test stresses. The day's loser list included Barclays (NYSE: BCS), Lloyds (NYSE: LYG), Royal Bank of Scotland (NYSE: RBS) and Credit Agricole (NYSE: ACA). Deutsche Bank (NYSE: DB) cannot even escape concerns, with worries about the German bank's use of accounting rule changes to avoid writedowns. The Swiss banks are favored by some due to their heavier write-downs, but Swiss banking business also took an important hit when the banks agreed to give up names to the US IRS (so I am not in that boat). There also remain significant concerns about second tier regional banks that have been exposed to real estate revaluation.

The Difference in Shoe Sizes

The situation is just messier in Europe because of the European way of life. As the EU tries to implement US tactics, I expect they will discover they do not fit as well over there. I must admit to admiring and enjoying the European way of living, for the few weeks of the year I used to soak it up. However, it's clear that this relaxed attitude can no longer extend to business, or the euro will sink to below parity.

Disclosure: No positions