Owing to fundamental risks, European bank stocks have declined sharply as fears escalate over the eurozone sovereign debt crisis.

Restricted funding options

The worsening sovereign debt crisis affects European banks in two significant ways. First, in funding their balance sheets, European banks are highly reliant on wholesale funding. Wholesale funds are used to supplement traditional retail deposits and come from a variety of sources, such as foreign deposits, where the prices are linked to the cost at which the domestic government can borrow. For many banks, deteriorating conditions have raised the cost of this funding and, in some cases, access to wholesale funding has been shut off completely. Second, these banks have large direct ownership of sovereign bonds, whose declining values could represent a significant hit to the banks’ capital.

Growing risks: Italy and Spain

Contagion of the debt crisis into Italy and Spain is a significant risk for most European banks, given the sheer size of exposures and interconnectedness. My research suggests that the European banking system could manage exposures to Greece, Portugal, and Ireland in the case of some form of default, although domestic banks within these three countries have greater vulnerabilities. However, bank exposures to the sovereign debt of Italy and Spain are significantly larger. While defaults in these countries remain a small possibility, even short of a default, any valuation adjustments to their sovereign debt could have a considerable negative impact on European banks.

Restructuring package a helpful start

I believe the eurozone debt restructuring package announced in July will be helpful, but does not completely solve the problems facing Europe, and downside risks remain. In my view, two key aspects must be addressed:

1. Greece needs time: The need is for a program that is more sustainable than just pouring liquidity into an effectively insolvent country. The EU had been fixated on liquidity, but unlike other affected nations, Greece faces a solvency issue, due to the sheer size of the debt burden relative to its small economy. That said, the advantage of the package is that the risk of a near-term, disorderly liquidity event has been avoided, and will continue to be avoided as long as Greece delivers on its promises.

2. The crisis must not spread: A strategy is needed to deal with the self-fulfilling nature of the crisis. The authorities must work to prevent the problems in Greece, Ireland, and Portugal from infecting Italy and Spain, or any of the larger eurozone economies. A positive surprise of the debt restructuring package was the announcement that the scope of the European Financial Stability Facility (EFSF) would be expanded to enable supporting other countries’ debt in the secondary market. Previously, the EFSF mandate was limited to buying debt issued in Greece, Ireland, and Portugal in the primary market, and it could not intervene in non-program countries such as Italy or Spain. This expansion could be key to helping prevent contagion. However, details of the plan are vague, giving the markets limited confidence that the EFSF could intervene in a timely manner, and whether it will be enough, given the size of the Spanish and Italian sovereign debt markets.

On August 5, the European Central Bank restarted its Securities Markets Programme and began purchasing Italian and Spanish bonds on the open market to help support prices and reduce the risk of rising yields. This should help ease concerns about the timeliness of the EFSF intervention. Early signs are positive, but it is too soon to determine the success of the program.

Financials sector investing in this environment

The worsening sovereign debt crisis is a key negative risk to bank share prices and the reason for our relatively defensive positioning with European banks. We continue to take a cautious view and do not believe the potential risks are fully priced into many European bank stocks.

We currently have a preference for banks in the United States, Asia, and emerging markets, where downside risks are lower than in Europe and share prices have fallen significantly, creating interesting valuation opportunities.