On July 23, the Committee of European Bank Supervisors (CEBS) released the results of their 'stress tests' of 91 European banks. Only seven banks failed the tests, and as a result they will be required to raise EUR 3.5 billion in capital to shore up their balance sheets. While there are concerns that the tests were not 'stressful' enough to be of any real use, similar tests done in the US last year reassured investors of the banking industry’s financial viability and coincided with the stock market's massive rally off its lows of March 2009. Investors who believe a similar scenario could unfold in European markets may find a bank-specific ETF the best tool to capitalise on their thesis.
The CEBS tested each bank individually to see how they would respond under certain crisis scenarios, such as a double-dip recession or a sovereign bond crisis. To pass the test, the bank would have to maintain a tier-one capital ratio above 6% under each scenario. While this threshold is similar to the one used in the US stress tests, those tests included a more stringent 4% tier-one common stock ratio requirement. But whether or not the tests were too easy is perhaps a moot point; the true test will be the resulting level of investors’ confidence in the results.
The Bank Stocks
Morningstar's equity research department covers a dozen banks trading in Europe that are included in one or more of the major bank-specific indices. While the majority of the banks are trading at 20-25% discount to their fair value estimates, the high level of uncertainty surrounding the industry means our analysts believe that the current margin of safety may not be quite wide enough to consider purchasing the stocks individually. Expectations are that most of these higher quality banks are past the worst losses of the cycle, but that the levels of growth and profits of the 2005-2007 era are not returning any time soon. Future growth will likely come internationally, and banks such as HSBC and Santander already conduct 40-50% of their business outside of Europe.
Choosing an Index
Of the seven banks that failed the tests, none are considered major players in Europe, and none are included in any of the three main European banking indices, the EURO STOXX Banks index, the STOXX 600 Europe Banks index, or the MSCI Europe Banks index. While the EURO STOXX index only includes banks based in the European Monetary Union countries, and the MSCI excludes Swiss banks, the correlation between the three indices is high. Ultimately, the higher number of components, greater geographic diversification and the greater number of ETFs tracking it make the STOXX Europe 600 bank index the best choice for most investors, in our opinion.
Choosing an ETF
Among the six STOXX 600 Banks ETFs, only iShares offers a product that uses physical replication. While it is fairly popular, investors do pay a price for the physical replication in terms of a higher total expense ratio (TER). It, along with Lyxor's product, is also the only one to distribute dividends instead of reinvesting them. Although ComStage's offering has a slightly lower TER, the combination of a competitive TER and the largest trading volume and assets under management will likely make Lyxor's ETF the best choice for many investors.
So far, the markets appear to have liked what they've seen from the stress tests. Shares of the banks that passed the test have risen, inter-bank interest rates and costs for insuring bank bonds using credit default swaps have decreased, and the frozen debt markets appear to have slightly thawed as some banks were able to raise funds, albeit at a higher than normal spread. But while there is potential for elevated returns from the bank sector in Europe as the economy recovers, the industry is not out of the woods yet.
One of the largest complaints about the stress tests concerned the absence of a scenario involving a sovereign default in Europe. Many investors feel that the haircuts on sovereign debt would be much higher in reality than those assumed in the stress tests. Also, the tests only looked at the impact on the banks trading books, and not on any bonds classified as held-to-maturity. While a default may be a low-probability event after the efforts of the eurozone to bail out Greece, it would still be a high-impact event. A position in European banks is a risky bet, and should be limited to only a small portion of a prudent portfolio.
