Which European banks are the weakest link?

Stress has returned to the European banking system less than a week after a solution for Credit Suisse CS had been announced.

Shares in European banks have traded down through March 24 around midsingle digits, with Deutsche Bank DB taking the brunt of it, down 15% at its lowest point intraday.

We maintain our fair value estimates and moat ratings across our European banking coverage.

As we highlighted in a note on March 17 about the troubles at Credit Suisse “We Don’t See Contagion Risk for European Banks From Credit Suisse’s Woes,” we believe European banks are on a solid footing.

Capital and liquidity levels are good, and European banks do not suffer from asset-quality issues, which typically lie at the center of banking crises that spread quickly and widely.

We also mentioned that the read-across from the Credit Suisse fiasco is that profitability is king.

Low Profitability Banks at Risk

Building on this, we believe banks with low profitability outlooks (Commerzbank CRZBY), in the middle or toward the end of a substantial restructuring (Commerzbank and Deutsche Bank), and banks with more opaque investment banking and off-balance-sheet exposures (Deutsche Bank, Societe Generale SCGLY, and BNP BNPQY) are likely to be most hit by any type of broad sector declines.

That said, none of the banks mentioned suffer from any problems remotely comparable with those faced by Credit Suisse.

Despite our view that European banks remain solid and that we currently don’t see any credit or capital event, which would cause us to doubt the viability of the sector, we need to emphasize that even healthy banks can fall victim to a loss of confidence. In part, we believe that this is driving the selloff in European banks more broadly. With Credit Suisse out of the picture, markets appear to have moved on and reassessed exposures across the sector, with investors asking: which bank now poses the weakest link?

Given Deutsche Bank’s recent return to profitability, much of it stemming from more volatile investment banking, and an ongoing flurry of compliance issues supporting the general view that risk controls and compliance issues are of a structural nature at Deutsche Bank, it is not surprising to us that the bank is taking the lead in the European banking selloff. What we are less certain of is the cause of the dramatic spike in credit default swaps on Deutsche Bank’s debt since March 23.

While an increase in credit default swaps is expected as investors start to rerate a bank’s perceived riskiness, we are surprised at the speed and magnitude as well as the movements being seemingly unprovoked.

Central banks in Europe and the US have continued increasing interest rates over the last week and a view that this may amplify the pain felt in the economy is solidifying. That said, it remains to be seen whether such large moves in credit default swap prices is justified.

From our point of view, Deutsche Bank is being strapped in front of the wagon in another blow to confidence in European banks. While this explanation is deeply unsatisfying to us, we fail to see worrying fundamental issues in the European banking sector or for Deutsche Bank in particular. But then again, the risk for European banks at the moment is that investors’ concerns, whether they are justified or not, will force fundamental issues into existence.

Last, Deutsche Bank announced that it will redeem a Tier 2 note worth $1.5 billion not due until 2028 at full value plus accrued interest in what we believe to be an attempt to show strength. However, it doesn’t seem that is has done the trick.