Euro banks: Bail-in trend could mean investment opportunity

We are in my view getting closer to an overall framework for the recapitalization of European banks, if executed properly this new norm could become the ultimate solution for solving banks capital issues throughout the European continent…in the long-run. In the short run, we might see additional havoc and shareholders will have to pick up the bill.

But there are trading possibilities here.  All bank share valuations are currently depressed, but not all banks will face a "bail-in" with share dilution.  Choose the right bank - and I have no idea which of the banks in the unhappy red box below might be correct - and you will get the benefits of the continental rescue with none of the dilution.  But within that box you will find the big gainers in any risk-on scenario. 

Let's look at the chart.  Credit Agricole is trading at estimated Price-to-Book of 0.16 and Unicredit at 0.23 for 2012. Issuing new shares at these valuation levels will greatly dilute the existing shareholders. On the other hand this dilution is likely to have been priced in already, chart 1.

Bail-out could become bail-in as government officials recognize that giving bank shareholders “tough love” is the only way forward to create a credible solution that makes both political and financial sense. The bail-in model enables governments to inject capital, which can be converted to shares, directly into the banks. This secures some low hanging political victories as banks’ shareholders take the hit. This model has been implemented previously with great success in cases such as Sweden following the real estate crisis in beginning of the 1990’s. This will ultimately mean that many banks will be more or less nationalized. Although this might be terrible news for shareholders, it makes great financial sense since it enables banks to be more long-term in the restructuring process of the credit portfolios. Nordea, Scandinavia’s largest bank, is a good example of bank that went through this process and now enjoys one of the strongest balance sheets in Europe.

Some of the largest banks in Europe are in the danger zone of needing additional capital; on the other hand, the sheer size of these banks in some cases disables existing shareholders to perform a straight-out rights issue, chart 2. This constitutes a catch 22 for existing shareholders but a possible opportunity other investors in the medium term as stock prices will fall dramatically in the short term on the back of industry uncertainty.

The extreme risk in the European banking system, have largely been accounted for if we look at the whole sector combined. There will without doubt be banks ending up in custody of some European government, but overall there will in my mind be more positive than negative surprises. That is if European regulators pull themselves together and chose bail-in instead of bail-out. The future will tell.

I write regularly about the top 20 international banks for TradingFloor.com.  If you'd like to be notified every time I post something new, become a member of TradingFloor.com - it's free! - and you can sign in with Twitter, Facebook, LinkedIn or Google - and follow me or "Financial Services and Banking." You can also follow me on the Tomas Berggren page.