European banks have $188 Billion at risk from Greece, Ireland, Portugal, and Spain. Excluding default risk, those banks are still woefully short of capital according to a study coming out tomorrow.

Please consider European Banks’ Capital Shortfall Means Greece Debt Default Not an Option

The “fragilities” of Europe’s banking industry mean a Greek default isn’t an option, European Union Economic and Monetary Affairs Commissioner Olli Rehn said in New York last week. By delaying a decision some investors consider inevitable, policy makers risk increasing the cost to European taxpayers and prolonging Greece’s economic pain.

“European officials are trying to buy time for the troubled economies to get their house in order and the banks to be strengthened,” said Guy de Blonay, who helps manage about $41 billion at Jupiter Asset Management Ltd. in London.

While estimates of the capital shortfall vary, the vulnerability of European banks to a sovereign shock isn’t disputed. Independent Credit View, a Swiss rating company that predicted Ireland’s banks would need another bailout last year, found in a study to be published tomorrow that 33 of Europe’s biggest banks would need $347 billion of additional capital by the end of 2012 to boost their tangible common equity to 10 percent, even before any sovereign default.

European banks had $188 billion at risk from the government debt of Greece, Ireland, Portugal and Spain at the end of 2010, according to a report this week from the Bank for International Settlements. European lenders held $52.3 billion in Greek sovereign debt, with German banks owning the biggest share, the BIS data showed.

European banks are trading at 0.83 times book value, according to the banks index, almost the widest discount since the end of 2008 to their U.S. counterparts, which trade at 0.94 times book, based on the 24-member KBW Bank Index. (BKX) The five-year average price-to-book ratio of the 51 European lenders is 1.34, data compiled by Bloomberg show.

That banks in both regions are trading below book value indicates investors don’t believe their assets are worth as much as the companies say.

Low market valuations make any potential capital-raising more dilutive for shareholders, said Simon Maughan, head of sales and distribution at MF Global Ltd. in London. Questions about regulatory requirements are adding pressure on bank stocks, making a quick recovery unlikely, he said.

“The big issue behind why price-to-book ratios are well below averages is that the market is saying banks can’t make a proper return and certainly not a return anything like they’ve been used to getting,” said Maughan.

EU regulators are seeking to assuage investors’ concerns about capital with a second round of stress tests on 90 lenders. The European Banking Authority is promising tougher tests this year after failing seven of 91 banks last year and finding a capital shortfall totaling 3.5 billion euros, or about a 10th of the smallest estimate from analysts. Ireland’s biggest banks needed a rescue four months after passing the test.

Tests carried out in the U.S. in 2009 found 10 lenders including Bank of America Corp. (BAC) and Citigroup Inc. needed to raise $74.6 billion of capital. The banks were required to raise the funds from private investors or accept government aid.

Mark-to-Fantasy Asset Valuations

Bank stocks have been in the gutter because of mark-to-fantasy accounting. No one believes asset valuations, and no one believes results of existing stress tests.

Few will believe the results of the next one.

Only 22% of Respondents Expect Next Stress Test will be Credible

The Wall Street Journal reports Spanish, German, Greek Banks Seen Failing Stress Tests -Survey

Banks from Spain, Germany and Greece are expected to have to raise the most new capital following the next round of European stress tests, according to a survey of investors by Goldman Sachs published Monday.

But the survey of 113 fund managers, mostly from hedge funds and long-only investors, also found that only 22% of respondents expect the test to be a “credible reflection of bank resilience,” highlighting the lack of credibility of the stress test.

Last year’s test rubber-stamped the balance sheets on several banks that later fell on hard times, including Irish banks that a few months after the tests were published had to be bailed out.

According to the Goldman survey, investors expect the stress tests to show that banks will need another EUR29 billion in fresh capital. It expects 90% of the banks included in the test to pass. Investors on average expected nine out of the 91 banks that will take the test to fail, down from 10 institutions that failed last year’s stress tests.

The stress test should include default because default is the epitome of stress. Default is also highly likely.

The expected result of the stress test is a mere EUR29 billion in fresh capital ($42.5 billion US) for 91 banks. Compare that to Credit View’s analysis that shows 33 banks, need $347 billion in capital, not counting a risk of default.

Mike “Mish” Shedlock
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