Be Careful of These Bank Stocks

By Sasha Cekerevac for Investment Contrarians | Oct 22, 2012

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Recent analysis by management consultants regarding stress tests for bank stocks within the eurozone are showing more signs of concern for investors around the world. One of the biggest concerns is the eurozone’s Spanish banking system. Spanish bank stocks have seen their bad loans increase as a percentage of total lending for 17 straight months. According to Bloomberg, bad loans went up 0.72% in 2006 and stood at a massive 10.5% in August. (Source: “Spain Banks Face Pain as Worst-Case Scenario Turns Real,” Bloomberg, October 18, 2012.)

That is a shocking increase for bank stocks to deal with, considering the economy is still in decline. The eurozone itself is experiencing massive economic difficulties, and there appears to be little relief for bank stocks in that region over the short term. Bloomberg also noted that management consultant firm Oliver Wyman Group considered a decline of 6.5% in Spanish economic activity from 2012 to 2014 during its stress test. What was surprising to me was that the Bank of Spain only gave this scenario a one-percent chance of occurring. I’m not sure how they came to that figure, but a six-percent decline is very realistic for the Spanish economy over the next couple of years.

The problem for the eurozone is that bank stocks within the union have assets that continue to underperform, this creates a reduced incentive to increase lending and transactions that are needed to grow an economy. Much like an individual who has taken on too much debt, bank stocks have less excess reserves to spend, and even less willingness to spend them. Bank stocks are obviously an integral part of any economy, and if they are undercapitalized, this reduces their willingness to lend and help businesses grow. The eurozone has severe structural issues, with the Spanish bank stocks being especially crucial.

But it doesn’t end in Spain. Moody’s recently issued a warning that bank stocks within Germany are susceptible to downgrades. This is due to rising risks within the eurozone, lower profits, and reserves too small to handle any shock to the financial system. (Source: “Moody’s Warns of Weakness in German Banking Sector,” The New York Times, October 19, 2012.)

The problem with German bank stocks is that they are inextricably tied to the economies of the weaker nations within the eurozone, including Spain and Italy. The increased interconnectedness with bank stocks around the world, and especially the eurozone, makes it difficult to properly evaluate the true risks involved. Bank stocks have come a long way from the time when they would lend money to neighbors in a little community. In the new world of globalization, while there are massive rewards, there are also some risks.

The main takeaway that I would suggest for investors interested in bank stocks is to focus on regional banks that generally have little or no exposure to the eurozone. At some point, the eurozone crisis will hit a bottom and, at that point, looking at bank stocks within that area would be a good idea. But it might take years before the bottom is hit. Until that time, I would expect more pain to ensue within the eurozone, especially within bank stocks that are heavily leveraged there.

Tags: bank stocks, eurozone