Steer Clear of European Banks' Current Capital-Raising

by: Alicia Damley, CFA

This week marks the beginning flurry of capital-raising amongst European banks – a good sign, given the urgency for capital ahead of weak core Tier 1 ratios, more stressful bank stress test assumptions than last year’s, weak growth outlook and continuing PIGS sovereign debt problems foreshadowing worsening resolution choices. However, it is premature to broadly step back into European banks for a number of reasons.

With more banks remaining to raise capital, market appetite and capacity for bank paper remains to be tested. Tightening of Tier 1 eligibility under Basel III means the banks have less flexibility and their cost of funding has risen. Insurance companies, natural buyers of bank paper, have been reducing their exposure and, more importantly, are focused on countering declining yields in their investment portfolios.

Added to these private sector bank requirements are substantial capital needs resulting from yet to come over-due restructuring of the German, Spanish and even Italian public sector banks. Lower profitability and balance sheet weaknesses of the public sector banks will test government resolve and finances to address what has become a problem that cannot continue to be put off.

The sovereign debt crisis remains unresolved. Portugal is set to tap the EFSF and Spain continues to teeter towards it. In its current form, the EFSF does not have sufficient resources to cover both countries. Terms to be agreed to on sovereign debt crisis resolution will further influence the amount of capital the banks will require. Wholesale funding requirements remain elevated, raising cost of funding and lowering profitability. Bank paper investors may not yet have completed analysis of future profitability trends driven lower by Basel III capital and liquidity requirements, weak growth and margin compression (see here).

European banks will present a buying opportunity, but not just yet.

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

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