By Matthew Goodburn | 13:45:32 | 21 May 2010
Europe’s banks are enduring another bout of deleveraging, risk assets are falling and the dollar is climbing on its ‘safe haven’ status.
With the sovereign debt crisis continuing to weigh, investor sentiment towards Europe is at historically low levels. Are we seeing a timeline of events that could ultimately lead to another credit crunch for some of Europe’s comparatively undercapitalised banks?
A number of comparisons can be drawn between what is happening now in Europe and the onset of the credit crunch in the US in 2007 with some experts regarding the onerous sovereign debt levels of the southern European countries as Europe’s equivalent of sub-prime.
Numis analyst Robert Law points out that a reversal of Europe’s financial balance sheet is underway with the surpluses of core Europe switching over with the deficit on the periphery, or in this case particularly the southern Mediterranean countries.
As the financial sector enables these transactions, it is at the frontline of exposure to the issues.
‘If these imbalances are unsustainable you then get losses in the financial system and these losses can be exaggerated if the process of closing them is too rapid, or too disorderly,’ he warns.
Any significant deleveraging is likely to be negative for banks because they are geared to risk, so they are also likely to be geared to markets at the same time, he says.
Law points out those most European banks have not recapitalised as zealously as their UK and US counterparts and that any additional losses could lead to another bout of solvency and capital ratio concerns.
He concludes that at the very least, there are likely to be earnings downgrades related to trading exposures, followed by increased credit loss assumptions.
But Laws says there are two significant differences what happened three years ago, and what is happening this time in Europe.
First, the speed at which authorities react to liquidity issues will be much snappier than before, and second, Laws argues that the potential losses this time will be ‘substantially less’ than in the sub-prime and ensuing credit crunch crisis.
Law says that even on the most aggressive assumptions of losses relating to an eventual restructuring of Greek debt, and sharply increased losses on the private sector debt in Spain and Portugal, most European banks would not see much above 15-20% coming off pre-tax book value, and around 10% post-tax, or roughly equivalent to one year’s profits.
‘Furthermore, it will be interesting to see how much of any eventual cost is ultimately borne by the public, through refinancing packages, rather than assumed by private markets,’ he adds.
The European banking sector has already seen a 20% decline from its 2010 peak in the last few weeks and Law argues that southern Europe’s sovereign debt problems are in the price.
‘As in previous downturns, investors are likely to focus valuation back towards book from normalised earnings and if the process intensifies, towards the potential write-downs to book.’
But Laws expects the losses to be unevenly spread, with those banks most exposed to southern Europe most affected, along with those with relatively weaker capital ratios.
His preferred picks in the sector are from the core European countries, as well as from the UK, Scandinavia and Switzerland.
For the UK he concludes that Lloyds is likely to see some positive earnings revision, but is keeping an eye on Barclays for its relatively higher exposure to southern European markets, through its local business in Spain and Portugal.

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