After months of indecision, last week saw movement in the European sovereign debt and European bank sector crises. As key details of the response have emerged, more useful analysis has been enabled.
First, while the severity of the stress test assumptions has been debated, the report on the results of the European bank stress tests includes useful by-bank data, particularly on the gross and net holdings of individual country sovereign debt exposure. The data is naturally in line with BIS aggregate figures but provides important granularity. A review shows that while the bulk of Greek, Portuguese and Irish sovereign debt is held by domestic banks, the remaining debt-holding profile is still concentrated in the German and French bank sectors. While the debt is held in the loan books, it is classified as available-for-sale, requiring write-downs to flow through the income statement. As the size of the haircut on Greek debt becomes clearer, more accurate calculations for each bank’s write-downs become possible.
While much of the immediate focus has rested here, two other key takeaway from the report warrant attention. First, unlike its US and emerging market peers, the sector’s reliance on wholesale funding is still high -- 29% at the end of 2010. During the second half of 2011, €613 billion is expected to mature. Combined with continuing competition for domestic deposits, the cost of funding for European banks will continue upwards with the report estimating an increase of 42% in 2011 and 27% in 2012.
Secondly, under the adverse scenario, while losses on sovereign debt are substantial, these will pale in comparison to loan losses under the adverse scenario. Under weakening economic conditions, adverse developments in the loan book become increasingly crystallized. In this context, aggregate estimates on sovereign debt of €11.5 billion will be dwarfed by aggregate loan book losses of €365.4 billion. While the sovereign debt crisis has been damaging to the sector, its contribution to weakening underlying economic conditions will be even more damaging. Re-build of capital in the European bank sector continues to be urgent; the sector is already below its global peers under Basel III. Most large US banks have already re-built to Basel III capital of 8%. Furthermore, it is important to note that using this 8% threshold, the European bank stress tests would have failed 53 out of the 90 banks tested.
Details available on the Greek sovereign debt haircut suggest that the European insurance sector is more strongly positioned, providing the basis for the reversal of sector under-performance in the last quarter. Driven by regulatory standards, insurance companies are amongst the natural buyers of sovereign debt. However, since mid-2010, most large insurers have been both reducing their Greek, Portuguese and Irish exposure and putting up reserves against portfolio holdings. Upcoming second quarter 2011 results should provide confirmation that most large groups have higher reserves set aside than expected debt write-down. Importantly, unlike the banks, the insurers are not required to hold additional capital as sovereign debt ratings decline.
Given these developments, it is useful to recap recommendations for European financial stock holdings. As contagion risk spreads to Spain and now Italy, European politicians are being forced to address their debt crisis and ownership of European banks enters into the realm of possibility. In the financial sector, core European names throughout the crisis have included Allianz (OTCQX:ALIZF), HSBC (HBC), Munich Re and Svenska Handelsbanken (OTCPK:SVNLF). Each name is characterized by a strong balance sheet, resilient business franchise, strong position in key markets and proven operational competence. With recent developments, new banking names to consider, but with differing immediate risk profiles, include Credit Suisse (NYSE:CS), Deutsche Bank (NYSE:DB) and Intesa SanPaolo (OTCPK:IITOF). In each case, the sovereign debt exposure is manageable relative to capital, a round of capital-raising has been completed and the banking franchise remains strong.
Disclosure: I am long HBC, Allianz, Munich Re, Svenska Handelsbanken.