Stress Tests Ahead: 3 EU Banking Picks - Analyst Blog

Concerns about Europe's banking sector have intensified following the crisis surrounding Portugal's banking giant Banco Espírito Santo. Despite the optimism generated by the rescue plan unveiled by the country's central bank, questions about the industry have come to the fore. In this context, ECB's decision to conduct a series of exercises before it creates a Eurozone-wide banking watchdog gains special significance.

Banco Espírito's Rescue Plan

Last week, Portugal's central bank announced a rescue plan for Banco Espírito Santo (BES). BES had incurred a loss of €3.58 billion in first half of 2014. This is the biggest loss in Portuguese banking history. The central bank announced it will split BES into a "good bank" and a "bad bank." The 'good bank' will receive a bailout of €4.9 billion from the bank resolution fund.

Out of this, €4.4 billion will be provided by the Portuguese government as a loan and the rest as cash. Investors welcomed this plan as it may help Portugal recover from the banking crisis.

The "good bank" will be called Novo Banco. BES' potential assets such as deposits and loans, which can be repaid, will accrue to the "good bank." Good bank will use BES' existing branding and framework to continue its operations.

BES will become the "bad bank." The "problem" assets of the bank will remain with BES. Shareholders and the creditors will be liable for these assets and may lose all of their investments. The Espírito Santo Financial Group, which is one of the owners of BES, and Crédit Agricole (one of the biggest French lenders) are among those who stand to lose.

ECB's Asset Review and Stress Tests

The ECB has decided to create a unified watchdog for all Eurozone banks before the end of the year. Ahead of its assumption of formal control on Nov 4 this year, the ECB is carrying out an exhaustive evaluation of the health of banks in the economic union. This includes 128 banks that hold 85% of all banking assets in the 18 countries which use a common currency.

All the 28 members of the EU will also undergo stress tests to determine how they would respond to another economic slowdown and a slump in the markets. In the past, stress tests have performed poorly in achieving their objectives. Both lenders and their supervisors are sceptical about their efficacy since they have upheld the financial soundness of banks which have collapsed shortly afterwards. This includes the likes of Franco-Belgian bank Dexia which failed in 2011.

However, EU officials have emphasized that things will be different this time around. Firstly, banks can no longer depend on their national regulators to protect them from such measures. Secondly, the decision to conduct asset quality reviews ahead of stress tests increases the efficacy of such measures. The wisdom of such an approach has been borne out by their effectiveness in Ireland, Spain and Slovenia in 2011, 2012 and 2013, respectively.

Portugal's Action In-Line with ECB Approach

Portugal's approach is in consonance with the ECB's approach on resolving crises relating to troubled banks. The country has followed Spain's approach toward such situations by letting shareholders and junior debt holders take losses. This has spared senior creditors and unsecured depositors.

Though such an approach hurts shareholders and creditors, analysts believe that it is good for the banking industry as a whole. It is also in line with EU's new approach to tackling banking crises. New rules mandate that funds spent on stabilizing distressed banks be recovered from the private sector once the crisis is over. Earlier this month, the EU said the rescue plan for Banco Espírito Santo was in keeping with rules on state-aid.

Our Choices

The approach taken by Portugal's central bank shows that banks in the EU have taken a more prudent approach to tackling crises. Below we present three stocks from this sector which possess the potential to grow appreciably, each of which also has a good Zacks rank.

Banco Santander, S.A. ( SAN ) is the biggest bank in Spain as well as Latin America. It also operates across four segments: Sovereign, Latin America, UK and Continental Europe. The Bank provides banking services for individuals and companies, leasing, factoring, stockbrokerage and mutual fund services. Its European operations are conducted via Bank Zachodni WBK, Santander Totta and Santander Consumer Bank.

Banco Santander holds a Zacks Rank #2 (Buy) and has expected earnings growth of 14.8%. The forward price-to-earnings ratio (P/E) for the current financial year (F1) is 15.63.

Barclays PLC ( BCS ) is a major global banking and financial services company, with over £1.4 trillion ($2.1 trillion) in assets as of Mar 31, 2014. The company operates through an international network in over 50 countries and regions in Europe, the U.S., Africa and Asia, the company provides a wide range of financial services to individuals, corporations and institutions.

Currently the company holds a Zacks Rank #3 (Hold) and has expected earnings growth of 30.7%. It has a P/E (F1) of 10.13.

Deutsche Bank AG ( DB ) is the largest bank in Germany and one of the largest financial institutions in Europe and the world, as measured by total assets (1,637 billion as of Mar 31, 2014). As of that date, the company had 97,184 full-time employees and operated in 72 countries with 2,853 branches, of which about 66% were in Germany.

Apart from a Zacks Rank #3 (Hold), Deutsche Bank has expected earnings growth of 130.3%. It has a P/E (F1) of 8.76.

The ECB and banking regulators across the region have taken measures to ensure that stability returns to the sector. This is why these stocks would make good additions to your portfolio.

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DEUTSCHE BK AG (DB): Free Stock Analysis Report

BANCO SANTAN SA (SAN): Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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