Banking time bomb - banks' balance sheet risks are increasing

European and US banks have received their fair share of blame for the crisis in 2008 however present valuations indicate that the worst is yet to come. Some banks have lost more than half of their market cap since July resulting in valuation levels crumbling (see charts 1 and 2) posing a value trap of gigantic proportions for investors.



Valuations indicate disaster ahead
Current valuation levels indicate future distress, which will inevitably lead to capital increases in some of the major financial institutions. Recently, the International Monetary Fund indicated the European sovereign debt crisis has generated a whopping €300bn in extra credit risk! Furthermore, some sources estimate the capital shortfall in the European banking system today may be as large as €400bn, taking into account potential haircuts in PIIGS sovereign debt and a recession in Europe. This means that investors have to put up an additional €400bn just to keep the banks going in the current manner.
 
Capital is king – but expensive
The primary drag on a banking rebound will be how far the Basel committee and respective governments will go in implementing stricter capital requirements (Basel III). This will put extreme pressure on the profitability of the largest system critical banks resulting in them being required to hold extra capital to meet potential losses, while hoarding liquidity to live through a credit freeze in the interbank market. Despite this, analysts’ expectations are that return on equity will trend higher in the next three years. Either the market is wrong, trading the share at too low a level, or the analysts are wrong by failing to correctly estimate future earnings and book value. It looks like the latter is the culprit and analysts' views have to change. Either way major disappointments are on the cards - see charts 3 and 4.


US - Europe’s least ugly banking cousin
The US banking sector looks less dreadful than its European peer, primarily because of the political complexity intertwined in Europe’s sovereign debt issue.

Basically, being long banking stocks is being long credit. As the risk of a Western world recession increases, so will the risks to the banks’ balance sheets. Add to this picture the potential massive losses from the PIIGS' sovereign debt and the higher funding costs due to the malfunctioning interbank market and investors may be sitting on a ticking time bomb!