* ECB's review threatens broad bank rally
* Italian, Spanish lenders seen as vulnerable
* Nordic banks, HSBC to benefit from stronger balance sheets
By Francesco Canepa
LONDON, Oct 28 A four-month, largely indiscriminate rally in Europe's banking shares is under threat, as the European Central Bank's asset quality review lays bare the shortfalls of weaker institutions.
The wider-than-expected review into banks' balance sheets throws investors' spotlight onto lenders with problematic loan books, large exposures to sovereign bonds and rely on central bank funding, such as Spain's Banco Sabadell and Italy's Banco Popolare.
While details of the review are still unknown, the risk that some weaker banks will have to raise more capital means they may be axed from investor portfolios.
Shares in Sabadell, Banco Popolare and UniCredit have fallen between 3 and 5 percent over the past five trading days, compared with a 1 percent drop for the sector. The ECB unveiled parameters of the review on Oct. 23. Its results are due to be published in October 2014.
These three stocks rose roughly 30 percent, or three times as fast as the sector since late July, so they no longer look particularly cheap compared to peers with stronger balance sheets, such as France's BNP Paribas, Sweden's Svenska Handelsbanken (SHB) or London-listed HSBC.
"The opportunities right now are in the banks with the strongest balance sheets, which are best placed to generate capital in the (next) 12-18 months," Neil Wilkinson, European equities fund manager, Royal London Asset Management, said.
"After a period where southern European banks have done very well...my focus is back on the fundamentals and northern Europe again."
Stocks such as Spain's Sabadell and Popular and Italy's UniCredit and Intesa Sanpaolo have reduced their hefty price-to-book discounts to SHB by 20-30 percent since June, Datastream data showed, despite still having much weaker balance sheets than the Swedish bank.
Positioning by speculative investors also shows a market bias in favour of southern European banks, meaning any bad news from the review could have a big impact on their share prices.
Short interest - a measure of how many shares are out on loan to speculators hoping to sell them and buy them back more cheaply - in SHB is higher than in Intesa and UniCredit, Markit data showed.
A Barclays Capital study shows Sabadell, Popular, UniCredit and Intesa Sanpaolo are among the most vulnerable if the ECB requires them to increase their coverage ratio, a cash buffer banks must keep to cover potential losses.
SHB, HSBC, BNP Paribas and Switzerland's UBS and Credit Suisse, by contrast, are highlighted among the most solid.
"It's very difficult to understand what skeletons banks have in their closets," said James Butterfill, head of global equity strategy at Coutts.
"(But) if you buy these European banks individually, some seem much better capitalised than others," added Butterfill, who owns shares in BNP Paribas and UBS.
Given that some of the weakest banks are in southern Europe and financial stocks have a higher relative weight in southern European indexes, the recent outperformance of Italy's FTSE MIB and Spain's Ibex over northern indices could unwind as the review approaches.
Banks with large derivative holdings, including Deutsche Bank, may also feel the heat after the ECB's surprise decision to review the value of the least liquid assets, those included in the 'level 3' accounting category.
Level 3 assets, which include complex derivatives traded directly between investors, are thinly traded and therefore difficult to value, meaning there could be scope for surprises when the ECB makes its own assessment of their value.
"If the regulator is looking at stuff like level 3 assets rather than just the loan book there's potential pressure on some of the names," Benjie Creelan-Sandford, an analyst at Macquarie Research, said.
German lender Commerzbank's exposure to level 3 assets is twice as big as its tangible book, with Deutsche Bank and Portugal's Banco PBI and BCP all well above the 100 percent mark, according to Macquarie.
A writedown of the value of these assets would thus have a significant impact on the bank's overall capital position.
In this context, some analysts advocated avoiding euro zone banks altogether and focusing on lenders that would not be affected by the review, such as HSBC and Scandinavian lenders.
"You absolutely want to be hiding out in a bank where there's no risk of anything negative because they're not really in (the review)," Simon Maughan, head of research at Olivetree Financial Group, said.