Europe After the Bank Stress Tests

Europe After the Bank Stress Tests August 4, 2010, Bill Witherell, Chief Global Economist

European economic policy-makers must be pleased to have seen the last of the first half of 2010.  The sovereign debt crisis that depressed markets not only in Europe but also around the world has since eased, and investor confidence is returning to equity markets on the Continent. We will discuss the major developments underlying this change in market sentiment and the extent to which we think it is justified.

The key event that appears to have triggered the improvement in investor sentiment was the publication of the results of the stress tests of 91 European banks. These results indicated that only seven banks failed, with a surprisingly small aggregate capital shortfall of only 3.5 billion euros.  Analysts have criticized the stress tests as having been too lenient and lacking uniformity across Europe, with national regulators varying the assumptions and accounting standards employed.  While these criticisms are for the most part well taken, the tests did result in a significant increase in transparency with regard to the state of the European banking system, particularly with respect to sovereign exposures, the main concern of investors. 

We therefore agree with the remarks of Mario Draghi, chairman of the Financial Stability Board, that “The results provide additional clarity and transparency on the strength of the European banking sector….  The EU stress test exercise is an important contribution to bolstering confidence in the European banking system and strengthening the resilience and robustness of the global financial system.”

We have written about Spanish banks, arguing that while there are problems in the Spanish regional savings banks (cajas), the large banks are quite sound. The Spanish authorities felt strongly that the prevailing negative market sentiment with respect to the Spanish banking system was misinformed, and they pressed for publication of the stress test results on a broad basis across Europe. The Germans resisted as long as they could, realizing that this would reveal weaknesses in Germany’s state-owned Landesbank sector. In the end six of the 14 German banks tested (including Deutsche Bank, Postbank, and Hypo Real Estate) did not publish the detailed breakdowns of their sovereign debt holdings, despite the agreement to do so reached in the pan-Europe Committee of European Banking Supervisors. Hypo Real Estate was the one German bank to fail the test, and Postbank was a near-fail.

The tests confirmed our views of the Spanish financial system. Five cajas failed to reach the pass mark of a 6 percent tier-one capital ratio and will require another 1.8 billion euros in capital. Four others that just passed also will need funds. The Spanish government has made clear its intentions to inject the needed funds to the extent private sources fail to come forward. The larger Spanish banks passed with flying colors, even though Spain imposed a tougher solvency test than did the other large countries. One relatively small family-owned Spanish bank, Banca March, topped the stressed tier-one capital-ratio test at 19%.  More important are the results for Europe’s largest banks. The highest ranked are Barclays and the Royal Bank of Scotland, followed by Dexia, HSBC, Societe Generale, and Santander.

Investor confidence clearly was boosted by this exercise. Since publication of the results on July 23 through August 2, the iShares MSCI Europe Financials ETF, EUFN, has gained 9.8%.  European equity markets have been rallying. Over the same period the iShares MSCI German ETF, EWG, is up 3.78%; the iShares MSCI French ETF, EWQ, is up 5.28%; the iShares Netherlands ETF, EWN, is up by 2.92%; and the iShares MSCI Spain ETF, EWP, is up by 6.14%. Austria, despite its exposure to the troubled Hungarian economy, has seen its iShares Austrian ETF, EWO, advance by 7.43%. There are clearly other positive factors at play. Reported bank profits are looking strong, with, for example, robust profits reports yesterday by the major banks BNP Paribas and HSBC. These reports also stated that provisioning levels have been halved as expected loan performance improves. 

Another factor affecting financials was the easing of the proposed Basel III banking regulations. This may not prove to have been a wise move long-term, but it clearly eased near-term pressures on banks. We share the concerns of some analysts that the positive stress-test results may lead some banks to delay desirable strengthening of their capital positions.

The third factor has been a stream of encouraging reports on the state of Europe’s economies, with the German economy, the eurozone’s largest, playing the locomotive role.  German export orders are surging and capacity utilization is close to its long-term average. Also, Germany’s labor market is firming, which should be good for consumer sentiment.  Looking forward there may be some moderation in coming months to what have been exceptionally large advances in industrial production. In addition, the recent strengthening of the euro may start to temper export growth.

At Cumberland, in our International and Global Multi-Asset Class ETF portfolios, we are maintaining our positions in the German, French, and Dutch equity markets and have recently added positions in the Spanish and Austrian equity markets using the above-cited ETFs. Outside of the eurozone in Europe, we continue to like the prospects for Sweden’s well-run economy. The year-to-date total return for the iShares Sweden ETF, EWD, is over 17%, as compared with a 1.9% decline for the MSCI EAFE advanced economy EAFE benchmark index and a 7.5% decline for the MSCI Eurozone EMU index.

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