In the last few months, European Banks shares have been under extreme pressure. The index Eurostoxx Banks Price EUR is down 35% in the last 12 months, underperforming the Eurostoxx 50 index by 21%. Fearing a credit crunch in Europe, the European Central Bank (ECB) offered unlimited 3-year money (subject to collateral) in the long-term repo operation (LTRO), last December.
The European banks went all-in and raised almost €500bn, covering its short-term liquidity needs almost completely. At the end of February, there will be another 3-year LTRO, for which ECB's president Mario Draghi said recently he expects a liquidity demand on par with December's. With the benefit of this liquidity injection, bank shares had a huge rally (+16%) since the beginning of the year.
Source: Yahoo Finance
While the LTROs remove the immediate risk of a liquidity crisis, reliance on official support is not a long-term solution. It also reduces the average maturity of liabilities, based on the assumption that debt redemptions due in 2012 are financed by this liquidity instead of new long-term debt, increasing the duration mismatch, of assets and liabilities, in the balance sheet. Even for the P&L this can be negative because banks tapped the LTRO, with 1% cost of funding, and re-deposited the proceeds back with the ECB for a lower return (0.25% for very short-term deposits).
In case banks implemented carry trade strategies, buying bonds with higher yields than 1%, this could be positive for results, but to date it just doesn't seem to be the case, at least for major banks from central countries. As Mr. Draghi said, the banks/countries borrowing the most in the LTRO are not necessarily the same as those placing the biggest amounts in the deposit facility. Additionally, some banks think that tapping the LTRO carries a reputational stigma, such as German Deutsche Bank AG (DB), and didn't access the program.
Although the LTRO has removed the immediate risk of a liquidity crisis among European banks and triggered the sector rally in 2012, I think it's not enough to forget the long-term negative fundamentals. The operating, regulatory and political environment remains hostile for European banks. The macroeconomic outlook for Europe is weak, implying higher default rates in the next months and higher provision needs. There is also the sizable risk of a Greek default, and even if it doesn't default and can successfully implement a haircut, the contagion effects to other countries, such as Portugal or Ireland, can result in more losses for banks.
Banks are also required by Basel III to achieve higher capital ratios, but that has been extremely difficult or at very depressed prices, as shown recently by Italian bank Unicredit (OTCPK:UNCFF) when it asked capital from investors with a huge discount. The balance sheet deleveraging goals of European banks is also negative for revenues and profitability.
Although one of the main concerns for European banks (liquidity), seems to be resolved by the ECB injections, there are a lot of concerns to consider on a medium to long term basis, namely, balance sheet deleveraging, wholesale funding drought, higher capital ratios demanded and a weak macroeconomic environment. With another LTRO scheduled for the end of the month, European banks can continue the recent rally for a few more weeks but I think, for more fundamental driven investors, the risk-return profile remains negative.
In the short term, the uncertain outcome for Greece means that banks' performance is mostly binary. In case Greece defaults by March, the sell-off on these stocks can be huge. On the other hand, if an agreement is reached and Greece receives more money form the European Union and the IMF, the positive sentiment towards banks could maintain and the rally continue, until fundamentals return to the spotlight (possibly with 2012Q2 earnings release) and this view can be played through a long ETF, such as iShares MSCI Europe Financial Sector Index (EUFN).