* 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
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
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.