European Banks Don't Seem Overstressed

By SIMON NIXON We've done our bit, now it's your turn. That's what U.S. policy makers are telling their European counterparts. U.S. banks have passed stress tests, raised capital and many are set to repay government funds. European banks, so the argument goes, have done less to rebuild confidence in the system and are short of capital -- a view apparently shared by some at the European Central Bank. Is it true? The market doesn't seem to think so. European bank stocks have rallied alongside U.S. rivals since early March. Analysts no longer focus on whether banks have enough capital but what returns they can make as the economy stabilizes. Few now expect the Europeans to follow U.S. rivals and raise new capital from governments or the markets. In fact, European banks don't appear that stressed, based on criteria used for the U.S. Supervisory Capital Assessment Program tests. These required banks, under stressed economic scenarios through 2010, to have Tier 1 common equity to risk-weighted assets of 4% and core Tier 1 capital to risk-weighted assets of 6%. It is hard to make an assessment purely on published information, but Deutsche Bank reckons that, of 41 banks it has analyzed, just five would fail the common equity test. The saving grace for European banks was the U.S. decision to use risk-weighted capital measures for its test. On a total leverage basis, European banks don't compare so well. European banks have common equity equivalent to 2.8% of tangible assets compared with 3.5% in the U.S., according to Morgan Stanley. The International Monetary Fund recently estimated European banks will need an extra $600 billion of capital to ensure common equity to tangible assets remains at least 4%. But this higher leverage reflects the different ways U.S. and European balance sheets have evolved. U.S. banks were partly subject to an overall leverage ratio, while European banks were operating under Basel II, incentivizing them to run high leverage but retain assets that carried lower risk weightings. For example, European banks have higher exposure to corporate loans, equivalent to 43% of loan books compared with 26% in the U.S., while 16% of U.S. loans are in the relatively risky second-lien mortgage market, according to Deutsche Bank. Besides, European governments haven't sat on their hands. Every country has supported its banks, whether by providing capital, guarantees or insurance against toxic asset losses. Of course, European banks still face big challenges. Nordic banks are heavily exposed to the struggling Baltic states. Irish and Spanish banks face collapsing domestic economies. Unlisted savings banks in Spain, Germany and the U.K. may face particular problems. Meanwhile, the structure of European bank balance sheets may mean the big stresses only emerge later in the cycle as unemployment continues rising, corporate defaults pick up and some supposedly safe securities turn out to be risky after all. Meanwhile profits may not recover fast as the market expects. One reason analysts are relaxed about European banks: They are increasingly confident banks can generate enough capital organically to retain their strength as credit losses are incurred. But funding costs are rising, the future regulatory picture remains unclear and there's no guarantee buoyant investment banking revenues can be sustained. The market may be right that European banks can cope with these risks in the absence of further capital injections -- although, without a fully transparent European stress test, nobody can be certain. Perhaps the bigger concern is that the banks find themselves unable to provide the new lending necessary to support a recovery. But that's a potential problem for the U.S., too, despite TARP. Write to Simon Nixon at simon.nixon@wsj.com