European Banks: Invest or Divest?

Feb.18.11 | About: iShares MSCI (EUFN)

More than a year since the turmoil began, a resolution of Europe’s sovereign debt crisis continues to elude its political elite. Pronouncements of confidence in the banking system by governments and regulators have had little impact. Announcements of supposed large-scale guarantee program have proven insufficient. The realities of a few check writers (primarily Germany) and the very real political difficulties of selling the merits of this support to a dismayed German population have become a chronic situation.

Over this time, growing its way out of this crisis has proven illusory – growth outside of Germany has remained weak with no immediate prospect of improvement. Consequently, over the last 12 months the European banking sector has remained the weakest performer among global peers.

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The global financial sector has moved substantially from its crisis state more than three years ago, and the risk that the banking sector continues to unravel has diminished. Regulatory restructuring in Europe is beginning to yield change, particularly with the creation of the supra-national European Banking Authority.

The global financial crisis revealed that no regulator or central bank had complete data or even comprehensive risk indicators on the banking systems. Recent dialogue and preliminary data-gathering revisions have begun to ensure that a more comprehensive picture of risk in the financial sector will become available. The likelihood that the next ECB president will be selected from the Bundesbank has declined significantly.

This is good news insofar that it signals diminishing resistance to the ECB’s involvement in easing both sovereign and bank debt through bond buybacks. Some progress on bank pay and the consideration of contingent capital obligations (CoCos) in senior management variable-compensation offers the promise of better alignment between banks, government, regulators and, ultimately, dependence on the public’s purse. In directly owning CoCos, management will now become equity shareholders when bank operating performance is weakest and risk of failure highest, bringing downside risk closer. Overall, some progress has been made though it remains insufficient.

Yet a lot remains to be done, particularly about high and increasing levels of sovereign debt in parts of Europe. Banks through their holdings of sovereign debt are coupled tightly with sovereigns. Weaknesses in either banks or sovereigns intensify risk and contribute to their mutual downfall.

Furthermore, inter-connections between national banking systems act to propagate a crisis rapidly. As economic weakness outside of Germany continues, concerns are expanding inward from the peripheral countries. Limitations in the European Financial Stability Fund (EFSF; see here and here) are now clear, but alternatives are yet to be agreed upon. More than just increasing the size of the facility is required.

Capital-raising by European banks has just begun. With the next round of bank stress tests planned, the number of banks implicated and the amount of capital to be raised will only increase.

A longer crisis increases the risk of sowing broader weaknesses. Continuing global themes of below run-rate growth, exchange rate disputes and trade imbalances would worsen this impact. This week’s G-20 meeting in Paris presents yet another opportunity to address these issues, as well as the yet-unresolved sovereign debt and related banking crises. Political resolve, cooperation and compromise are essential, but continue to elude this global group of leaders. In the meantime, European banks limp along and should be avoided.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.