European banks can't seem to catch a break. As if the threat of a Greek restructuring weren't enough, the UBS (UBS) rogue trader incident has investors again facing the reality that these institutions are simply tough to manage.
However, regulators finally did something somewhat constructive last week. Faced with rumour and speculation that European banks are having difficulty borrowing U.S. dollars, the European Central Bank, in conjunction with the Fed and a host of other central banks, announced plans to expand the availability of short-term dollar funding through a coordinated lending facility. The announcement helped foster a rebound in credit spreads across the board, with European financials ending relatively unchanged versus a week ago.
Despite the actions of the ECB and the relative calm in the markets late in the week, problems in Europe continue to boil. While the prices of Greek bonds stopped dropping, they haven't increased, either. With one-year bonds still trading below 60 cents on the euro, the markets continue to price in a high probability of default as European regulators debate rather than compromise on a solution. Against this backdrop and in preparation to launch credit ratings on European banks, we've reviewed exposures to the sovereign debt of Portugal, Italy, Ireland, Greece, and Spain.
The following chart shows European banks exposure as a percentage of core Tier 1 capital, drawing data from filings, company presentations, and the released results of the European bank stress tests.
As the chart shows, banks tend to hold large balances of the debt of their home country. For example, Italian-based Intesa (ISP) holds more than 150% of its core Tier 1 capital in Italian government debt. For banks like Intesa, large write-downs of their government debt would have disastrous results for their capital positions and would most likely require some type of recapitalisation. Some banks, like Dexia (DEXB), ended up with PIIGS exposure even though they were not based in these countries, a result of their business models and the search for higher-yielding assets.
There are numerous outcomes for how the European sovereign debt situation will be resolved, from a disastrous contagious default and dissolution of the euro to a more benign support scenario where the ECB can allow the governments to muddle through their problems. It appears that each week, and sometimes each day, the market oscillates between one extreme and the other as to which scenario is the most likely.
Morningstar plans to release its European bank credit ratings at the end of September or early October.
