IF THE results of European bank stress tests were designed to draw a line under fears about the robustness of the system, then they failed miserably. The tests conducted on 91 banks across Europe were met with a hefty dose of scepticism from the investment community after only seven banks failed and the combined funding shortfall was “only” €3.5bn.
In contrast to the US, where banking stress tests in early 2009 helped foster confidence in the system and spurred an equity market rally, Europe is unlikely to follow suit. As Nic Clarke, a banking analyst at Charles Stanley, the stockbroker, says: “Ironically, the US stress tests improved investor confidence in US banks because 10 out of 19 failed and the capital injections required was significant so the market then felt the problem was being fixed.” He says the same is not true for Europe. “We still cannot say with high conviction that the European banking system is in fine health, as we are not convinced that the tests were tough enough.”
There are two main concerns with the tests. Firstly, that banks were only tested for an adverse scenario which had a five per cent probability of occurring. This equates to a one-in-20-year event. Yet the prospect of a Greek default does not seem that remote, especially if its austerity measures are not enacted in a timely manner. Secondly, analysts including Clarke would have preferred the regulators to use the core tier one capital ratio to measure the banks’ capital strength, which includes only the most liquid assets. “Overall, it will be a disappointment that many Eurozone banks have not adopted a ‘fortress balance sheet’,” wrote analysts at Morgan Stanley.
Going forward, investors need to be choosy about which banks to back, according to Morgan Stanley. Its analysts like BNP Paribas, Societe Generale, Barclays, UBS and Julius Baer. In contrast, Deutsche Bank, Deutsche Postbank and Hypo Real Estate all failed to disclose their sovereign debt holdings alongside their test results so they are at risk of punishment by the markets.
Another way for contract-for-difference (CFD) traders to make a profit from the European banking sector is to take a view on Euribor – the European interbank offered rate – the interest rate that banks charge to each other to lend on a short-term basis. In normal times, it is usually only a few basis points. However it peaks in times of stress in the banking sector and rose in the lead up to the test results: from 0.55 per cent on 12 July to 0.635 per cent yesterday.
If you think that the stress tests could raise more questions than they answered then this could put more pressure on the Euribor yield curve. Most CFD trading houses offer quarterly Euribor contracts. They often quote the price, which, like a bond, is inverse to the yield. So, if you think there will be a loss of confidence in the banking system then you would need to take a short Euribor position.
While investors are still unsure what liabilities exist on banks’ balance sheets, expect nervousness to abound.