European bank stocks have outperformed the market significantly since European Central Bank president Mario Draghi announced in July 2012 that he would do "whatever it takes" to save the euro. As markets absorbed this statement, the discount associated with the possibility of a eurozone break-up faded. In the following nine months, the shares of European banks have shot up more than 47% compared with just 12% for the FTSE 100. This impressive performance has led many investors to wonder whether there is still upside in European bank shares, or whether markets have got ahead of themselves. We argue that it is the latter that is true and that European banks are now, on average, fairly valued. We think their stock prices are built on the current calm in the market, which we see as mere complacency. We argue that significant risks to Europe's economic outlook remain, and that European banks will not return to their former profitability and instead will struggle to earn their costs of equity. Moreover, we think material risks remain to the market's generally sanguine view of European banks, as evidenced by Cyprus' recent deposit grab, and that at an average of 1.0 times tangible book, most European shares face more downside than upside.
The Key Question: Will the Rally Continue?
The rally in European bank share prices has piqued the interest of many investors, who are now asking whether the outperformance is likely to continue, and whether dips—like the one associated with the recent Cyprus deposit tax brouhaha—should be viewed as a buying opportunity. We assert that the shares of European banks are, on average, fully valued and that the current prices do not offer investors a sufficient margin of safety, given the still-large risks facing the European economy and the risk of additional shocks to the banking system. We think the recent events in Cyprus highlight the risk of unexpected negative shocks and demonstrate that the rules in Europe are being written as we go along.
Prices Assume a Certain Recovery
For all but the most troubled European banks, our fair value estimates are based on the assumption that there will be a slow economic recovery in Europe. In this scenario, we forecast that most European banks will, over the medium term, produce returns near their cost of equity (typically 12%), plus or minus a few percentage points depending on the quality of the bank's business model, geographic footprint and management. Our fair value estimates, therefore, tend to average 1 times book value.
However, we think this outcome is far from assured, as demonstrated by our fair value uncertainty ratings. With the exception of Banco Popular, which is rated extreme, all the major European banks that we cover carry uncertainty ratings of high or very high, which reflects our sentiment that investors would be wise to demand a 40%-50% discount to our fair value estimates before buying the shares.
Current market prices, now averaging 0.9 times book value, appear to reflect an underlying assumption that a steady, if slow, recovery is close to certain. Many European banks are trading near or above book value. These valuations imply that the markets expect these banks, on average, to earn their costs of equity without further diluting shareholders.
Little Upside for Bank Valuations?
European banks have increased their regulatory capital ratios dramatically since 2007 in response to market pressure and regulatory requirements. We've also seen improvement since the crisis in our preferred measure of a bank's capital strength, the ratio of tangible common equity/tangible assets (adjusting for international differences in accounting standards), although not as dramatically.
We continue to see many European banks as undercapitalised by this measure, and we think TCE ratios between 5% and 7% would be more appropriate (vs 4.6% at the end of 2012) and would better protect investors against the risk of further dilution should the European recession continue longer than expected. We assert that adequate levels of tangible common equity to unweighted assets are necessary to protect investors against the potential for gamesmanship in regulatory capital ratios and the risk-weighting of assets.
Excess Leverage a Key Source of Pre-crisis Profitability
While we stand behind our assertion that European banks currently hold too little tangible common equity, here we make a different argument: European bank leverage was outrageously high in the years leading up to the crisis, and this excess leverage was a driving force behind European banks' attractive profitability during those years. The average gross leverage of 11 of Europe's largest banks peaked at 42 times in 2008 and had fallen to 27 times by the end of 2012. This drop in leverage is echoed by an increase in Tier 1 capital levels over the same period.
Similarly, average return on equity was very high among major European banks in the years leading up to the financial crisis. It peaked at 18.8% in 2006, as banks leaned into the growing free-for-all situation in markets.
We project that leverage will continue to decline over time, and that return on equity will stabilise around 10% in the near term, far below pre-crisis levels. In the medium term, as Europe's economic recovery takes hold, we expect returns to increase to 12%.
The likelihood that excess leverage, rather than normal market conditions, was the driving force behind pre-crisis profits is reinforced by comparing return on equity with return on assets. We project a return to near-pre-crisis returns on assets, but this will fail to translate into pre-crisis levels of returns on equity because of lower, and still falling, leverage.
Conclusions
We think the rally in European bank share prices will soon run out of steam. Investors might want to consider taking advantage of the current generous valuations to reduce exposure to the sector. We consider the strongest, best-capitalised European banks to be 
HSBC (HSBA), Standard Chartered (STAN) and Julius Baer (BAER). Each of these banks, though based in Europe, offers significant exposure to faster-growing markets and is likely to report faster earnings growth than peers that are more tightly tethered to Europe. We note that Barclays (BARC) and UBS (UBSN) are both trading at a discount to our fair value estimates and both have new management teams that have staked their reputations on making the banks into less risky institutions.
