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European Banks Aren't as Healthy as Investors Think

Regulators and investors continue to focus on regulatory capital ratios rather than unweighted leverage ratios.

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As the European Central Bank prepares to complete yet another stress test of the European banks, we question whether it is focusing on the right metrics. Given the significant increase in the sector's stock prices over the past 16 months, we think investors might be too optimistic as well. We acknowledge that the banks are in better shape than they were, as the average core Tier 1 ratio has improved to 13.5% from 10% in 2010. However, we caution that European banks' unweighted capital ratios have not improved nearly as much as headline regulatory capital levels would lead one to believe. For example, one more relevant measure (tangible common equity/tangible common assets) shows that the majority of European banks fail to meet a reasonable 5% standard. Shell-shocked investors who think brighter days are here again for European banks should be more wary.

Has European Bank Health Really Improved?
The ECB is preparing to take over supervision of the majority of the euro-area banking system from local regulators in 2014 and perform a related "comprehensive assessment" of the banks it will supervise. We think the ECB will find most of the euro-area banks that we cover to be in fairly good health. European banks have been working diligently to prepare for the tests, with several announcing major balance sheet reductions or capital raisings in the back half of 2013. By most measures, European banks are much less risky than they were even a few years ago--Greek sovereign debt has been written off, peripheral European sovereign yields have fallen, more stable sources of funding have been found, and, most notably, regulatory capital ratios have improved materially. The average core Tier 1 ratio of the 22 European banks that we cover was an impressive 13.5% as of June 30, up 250 basis points from year-end 2010 despite the significant headwinds created by changes in how regulatory capital is measured. At the same time, the economic outlook for Europe has brightened. The United Kingdom's economic growth is accelerating, and the euro area is expected to emerge from recession in 2014, according to November figures from the Organisation for Economic Co-operation and Development. This improving outlook has not gone unnoticed by investors; a recent study by the Financial Times found that the number of European bank shares owned by U.S. investment funds rose 10% between June and November, helping to reverse the funds' sharp pullback from the sector in 2011.

Erin Davis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.