The U.S. has never really incorporated BASEL II. Essentially even today, U.S. banks (except for a few big institutions) are governed by BASEL I. One of the differences between BASEL I and BASEL II is that the later uses risk weight metrics, to guide banks on what type of assets they can buy. This means that as long as your balance sheet is comprised of relatively risk-free assets, the leverage on your balance sheet, when guided by BASEL II, can be quite high.
There are two problems with risk weight metrics. First, what happens when the risk-free asset that you have on your balance sheet is suddenly not so risk-free? Second question is, who decides the risk-weight metric of each asset?
As for the first question, when you are leveraged 50-1 one and all of sudden your risk-free assets are not so risk-free anymore (sovereign debt for example), you will probably lose all your capital. Assuming for example that a particular bank is leveraged 50 to 1 and there is a -2% swing in the value of the assets, capital goes to zero.
As for the second question, who decides the risks metric of each asset, the answer is the bank internally. Yes, banks have additional guidance from rating agencies, but how much leverage they undertake and how much risk each asset carries, is mostly an internal matter. There is not much regulatory guidance.
In the U.S. however, banks are mostly guided by leverage ratios. The risk of the asset plays no role, except for large institutions such as Citigroup (NYSE:C). So for the most part, U.S. banks have leverage under control, as per regulatory guidance. Due to these differences, European banks prefer to buy high quality assets of low yield, whereas, American banks prefer assets of lower credit quality, but of higher yield. As a result, European banks are much more leveraged than their American counterparts.
To give you an idea, lets look at the chart bellow:
In the above graph, I calculate the leverage by diving total assets by shareholders equity. It is not a risk weighted calculation, but we get some idea of the amount of leverage that each bank carries. One can also use liabilities as opposed to assets, to get the feel of tier1 etc, but I prefer to look at assets, because assets can gain or loose in value while liabilities, for the most part do not.
Deutsche Bank (NYSE:DB) with a leverage ratio of about 40, is the most leveraged of them all. And believe me, things were much worst last year. At one time, Deutsche Bank had a leverage of about 60. Commerzbank (OTCPK:CRZBY) is at 26.5 and Credit Agricole (OTCPK:CRARY) at 35. These are not small numbers.
In Deutsche Bank's case, if the average value of its assets fall by a mere 2,5%, it will wipe out its capital. In order for something like that to happen to Citibank , the value of its assets have to fall by about 9%.
Notice something else also. Deutsche Bank has almost double the assets of Wells Fargo (NYSE:WFC) but less than one quarter of the market cap. Also, Deutsche Bank makes a fraction of the money that Wells Fargo makes. This means that the assets that Deutsche Bank has, don't provide much of a return. It also means that Deutsche Bank will probably need to write-off additional assets.
Last but not least, take a look at the Price/Book. In all cases except Wells Fargo, the Price/Book ratio is below 1. In the case of Credit Agricole, the Price/Book ratio is about 0,35. This probably means several things:
The market does not believe the assets are worth what the balance sheet says
The company will need to write down impaired assets
The company will need to raise capital
All of the above
Credit Agricole will most likely write down impaired assets in the future. It will also probably need additional capital increases (secondary offering). That will more than likely dilute current shareholders (as has happened in Greece - more on that another day). The market realizes this and has discounted most European banks accordingly.
From their highs, Deutsche Bank has fallen 73%, Credit Agricole 83% and Commerzbank about 95%. So one might ask, why not buy at -95%? How much lower can they go? The answer is much lower.
If I am right about the vast amounts of capital that European banks will need, that means that shareholders will be diluted much further than they can imagine. There is the possibility that the market has factored in the capital increases, but you can never be sure. The German government for example bought about 25% of Commerzbank for $10 billion and is now loosing about 75%.
Citibank on the other hand, has written off (more or less) a lot of the impaired assets it once had and has been recapitalized. Also, there is a big difference when one is leveraged by a factor of 40 as opposed to a factor of 10. When you need to write down assets and you have a leverage of 40, there is not much room on the balance sheet to maneuver.
Yes U.S. banks also carry risk, but for the most part, these risks have to do with the U.S. economy itself. In Europe, in additional to the risks associated with the European economy, you also have a sovereign debt crisis, high leverage, impaired assets and of course capital increases ahead.
The bottom line is that European banks still have many hurdles to overcome. This means that their earnings will be depressed for some time to come and if I am right on the capital increases that need to be done, shareholder dilution will be much higher than what most investors imagine. On the other hand, most American banks, even money center banks, don't have these issues and as such, current shareholders are not exposed to dilution issues .
I can not find a reason for someone to be long on the European banking sector. If one wants to have the banking sector in his portfolio, prefer U.S. banks to European banks. The risks associated with European banks are just too high and the risk reward possibilities are not in our favor.
If for some reason we see a rally in the European banking complex, it will be a selling opportunity. And when the ECB magic fades (and it will fade), then they will also be a short sale opportunity.
In order for me to become bullish on European banks, I have to be convinced that assets have been written down and that the banks will not need more capital. I am not convinced of neither. As such, if you have European banks in your portfolio, it's probably a good time to sell them and think about buying U.S. banks. The risks in Europe are still too high.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.