The Hamilton Capital Global Bank ETF (HBG; TSX) is expected, over time, to hold ~25% exposure to European banks. Prominent among the ETF’s identified objectives is to generate yield and to limit volatility. As a result, in its European portfolio, HBG places a significant emphasis on Northern European countries, which are – on balance – wealthier than Canada/U.S. and have higher forecast GDP growth. Relative to U.S./Canadian large-cap banks, HBG’s Northern European holdings have higher dividend yields, and, of course, have significantly higher capital ratios (Canadian banks rank near the bottom globally).
Northern Europe represents a consequential percentage of the total European economy and banking sector. For example, of the 51 banks that underwent the most recent stress test, 13 (or 1 of 4 banks tested) were domiciled in Northern Europe. That said, it is likely none of these banks will be referenced in the financial press.
Which brings us to the results of this year’s EBA stress tests.
Even a cursory review of the results highlights the sector’s enormous diversity. The regulatory-driven tests are an attempt to bring transparency to bank balance sheets by quantifying the impact on the system from “material threats” (most importantly a significant decline in GDP) and communicate those results to the market. From the stress test results, we would identify four takeaways:
Takeaway #1: Dilution Risk to HBG’s European Holdings is Immaterial
HBG’s holdings held up well under the adverse scenario, with a fully-loaded portfolio-weighted common equity tier 1 ratio (CET1) of 12.9%, materially above the weighted-average for sector of 9.2%. In effect, under the adverse scenario, European banks in HBG had nearly 40% more capital than the “average” European bank tested. Even stressed, the European banks in HBG have ~20% more capital than the U.S. banks (at ~11.5%) and ~30% more capital than the Canadian banks (at ~10%).
As a result, with respect to HBG’s European holdings, we believe dilution risk is immaterial.
HBG’s two largest European positions – Swedbank (SWEDA, Sweden) and Danske Bank (DANSKE, Denmark) – performed very well. These two Northern European banks account for ~7% of HBG, and a quarter of its European bank allocations. Despite generally being “stressed” under more severe assumptions than the overall sector (Sweden assumed a cumulative 13% decline in GDP!), the banks’ results highlight their enormous capital strength:
- SWEDA had a CET1 ratio of 23% under the adverse scenario – i.e., still double the U.S. and Canadian banks. Its ratio as of year-end was 25.1%, providing significant support for its dividend yield of ~6.0%.
- DANSKE had a ratio of 14%. Its ratio as of year-end was 16.5%, supporting its dividend yield of ~4.4%.
Takeaway #2: Northern European Banks Continue to Stand-out Given their Huge Capital Ratios
Many of the best capitalized banks in the world are domiciled in Northern Europe, and this showed in the results. Even under highly conservative adverse scenario assumptions, this group still emerged with materially higher CET1 ratios than those of the Canadian and U.S. banks. In addition to SWEDA and DANSKE noted above, stand-outs include: (i) Swedish banks, SEBA (16.6% fully loaded CET1, 7.0% dividend yield), NDA (14.1%, 7.8%), and SHBA (18.6%, 4.4%), (ii) Danish bank, JYSK (14.0%, 1.9%) and (iii) Norwegian bank, DNB (14.3%; 4.9%).
Takeaway #3: Material Dilution Risk to the Overall Sector is Low (though Some Will Raise Equity)
We believe the results were generally in line with expectations. Given the adverse scenario is highly unlikely to ever occur, we believe the significance of the stress tests results is whether or not it implies a higher risk of regulatory-mandated dilutive capital raises.
Of note, only 5 of 51 banks had a ratio below 7% under the adverse scenario, a level we believe implies the highest dilution risk. As noted earlier, the weighted-average ratio under the adverse scenario was 9.2%. The straight-average ratio was 10.5% for the entire group.
With a sector average CET1 ratio in excess of 10%, we believe the stress tests results imply that material dilution risk to the overall sector is relatively low. This should not be surprising since tangible common equity for the European banking sector has risen ~€600 bln since the cycle began. Certain banks – including BMPS (Italy, already announced), as well as possibly RBI (Austria), UCG (Italy) and BARC (U.K.), the latter two being G-SIBs — could potentially raise equity, but in the context of a banking system with ~€1.2 trillion in tangible common equity and ~€25 trillion in assets, we do not expect it to be material/widespread.
Takeaway #4: Italian Bank Results Mixed; ISP Performs Very Well
The 5 Italian banks that were stressed had mixed performance, which is not surprising given the deviating metrics among the over 15+ publicly traded banks located in the country. Case in point, Italy’s two giants – Unicredit (UCG) and Intesa (ISP) – which together account for more than 40% of the total Italian banking sector assets; ISP performed very well, with a post-adverse scenario CET1 ratio of 10.2%, while the larger UCG, came in much lower at 7.1%.
Two other banks had ratios around 9%, including Banco Popolare (BP), whose result does not include a €1.0 bln rights offering it completed earlier this year ahead of its merger with Banca Popolare di Milano (PMI). As expected, Banca Monte dei Paschi di Siena (BMPS) had the worst result, and was the only bank to post a negative capital ratio (it concurrently announced a capital raise, the sale of its entire book of bad debt).
 See our HBG Manager Comment “On HBG, Seven Charts Comparing Northern Europe to Canada” (May 13), “On Capital, Canadian Banks Continue to Lose Ground” (June 9) and “On HBG, Significantly Higher Capital Levels than Canada/U.S. Banks”.
 We define Northern Europe as Norway, Sweden, Finland, Denmark and the Netherlands.
 This year’s test involved 51 institutions, including 37 within the eurozone, covering more than 70% of the bank assets in the EU and eurozone, respectively. The intent of the stress tests was to review the development of each bank’s capital position (assuming a static balance sheet) through 2018, under two scenarios: baseline and adverse. The adverse scenario, which was harsher than that used in the 2014 test, attempted to address the “most material threats” identified by the European Systemic Risk Board (the baseline scenario was provided by the European Commission) including: (i) a sudden rise in global bond yields (which are currently very low); (ii) a low nominal growth environment and its impact on bank profitability and (iii) rising debt unsustainability; and (iv) possible stress in the (growing) shadow banking sector.
 Sources: Barclays, European Banking Authority, Hamilton Capital.
 The average was 9.6% for the 35 publicly traded banks, and 8.6% for the global systemically important banks.
 G-SIB stands for global systemically important bank.
Note: Comments, charts and opinions offered in this commentary are produced by Hamilton Capital and are for information purposes only. They should not be considered as advice to purchase or to sell mentioned securities. Any information offered is believed to be accurate, but is not guaranteed.