The Real Reason to Stress about Europe’s Bank Test
By Paul J. Davies
Oct. 22, 2014 12:24 p.m. ET
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When everyone is staring in one direction, it often pays to look the other way.
European bank stocks have endured a wild ride as the continent’s stress-test results near. The European Central Bank is due to release them Sunday. Greek, Portuguese and some Italian and Spanish banks have suffered especially.
That is understandable. There are plenty of questions about European banks’ capital strength. And no one wants to own a bank that comes asking for more equity.
But too many banks have been tainted by this worry. So there is a good chance that solid, unloved institutions rally once the uncertainty of the stress tests is past and investors can refocus on the ECB’s stimulus efforts.
If, that is, the tests are credible. A lot rides on the stress tests for the ECB, which takes over eurozone bank supervision from national governments next month.
Its reputation will be based on its review of banks’ books and the stress tests.
The last tests under the sole supervision of the European Banking Authority were risible; several banks passed them only to require bailouts later.
Even with the ECB now at the helm, there is skepticism about how conclusive the tests will be. Europe, after all, has many competing voices and levels of economic health. Muddy political compromise is a near-inevitable outcome.
And the European tests can never draw the same bright line as did those in the U.S. in 2009. The ECB, for example, can tell a bank it must raise capital. But it can’t promise that a government will inject some if the bank can’t or won’t.
However, because the last European tests didn’t work and the ECB’s own credibility rests on the new ones, there is a decent chance they will be good enough. While some banks will indeed fail, investors may find there is opportunity to be had in a glass-half-full approach.
As things now stand, banks such as ING Groep of the Netherlands and Crédit Agricole or even BNP Paribas of France aren’t valued as recovery stories with big gains due from once-bad assets. Nor are they shunned as weaklings or firms overburdened by regulatory fines to come.
ING has cleaned up its balance sheet, sold insurance businesses and is cutting funding costs. Crédit Agricole has seen its capital base grow strongly, although a lot has come from investment gains in its insurance unit. BNP Paribas has yet to resolve a U.S. dollar-clearing ban that arose from its sanctions busting, but is performing well otherwise and should benefit from ECB monetary actions.
All three are valued at less than 0.9 times book value, while ING and BNP also have unchallenging forward price/earnings ratios of about 10 times. Crédit Agricole trades at 11.5 times forward earnings, but has a lower book value multiple of 0.6 times.
A credible-enough stress-test result could see these kinds of banks rerated. If BNP’s valuation moves up to the multiple of J.P. Morgan Chase ’s at about 0.94 times, for example, that would lift BNP’s shares more than 30%.
Investors with a higher risk appetite could also look at weaker banks that might still pass, especially if hedge funds have bet heavily against those stocks. Their prices could leap sharply if investors are forced to buy back stock to cover those short wagers against them.
Portugal’s Banco Comercial Português and smaller Spanish banks like Sabadell and Banco Popular Español have heavy so-called short interest, according to data from Markit Group. Notably, the second-most-shorted bank stock in the Stoxx 600 is ING.
Beyond the stress tests, Europe still faces low economic growth and low interest rates, so it will be some time before banks see lending and interest income growth. Then again, things have been so desperate that any signs of life would be good. And, should credible stress tests relieve capital concerns, European bank stocks will be looked at in a different way.
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