Europe's bank test celebrations mask mounting challenges

Investors were spared immediate pain on Sunday after the European Central Bank's landmark banking health check did not force massive capital hikes amongst the euro zone's top lenders.

But the sector's long-term attractiveness has been damaged by revelations of extra non-performing loans and hidden losses that will dent future profits.

The ECB said on Sunday the region's 130 most important lenders were just 25 billion euros ($31.69 billion dollar) short of capital at the end of last year, based on an assessment of how accurately they had valued their assets and whether they could withstand another three years of crisis.

The amount of new money needed falls to less than 7 billion euros after factoring in developments in 2014, well shy of the 50 billion euros of extra cash investors surveyed by Goldman Sachs in August were expecting. That means existing investors will only be asked for a fraction of the demand they expected in order to maintain their shareholdings.

But, those who read the details of the ECB's proclamation on the health of the euro zone banking sector would have seen more ominous signs too, as the ECB pointed to the amount of work that remains to be done to restore the region's lenders.

CHALLENGES AHEAD

The review said an extra 136 billion euros of loans should be classed as non-performing - increasing the tally of non-performing loans by 18 percent - and that an extra 47.5 billion euros of losses should be taken to reflect assets' true value.

"Banks face a significant challenge as the sector remains chronically unprofitable and must address their 879 billion euros exposure to non-performing loans as this will tie-up significant amounts of capital," accountancy firm KPMG noted.

Others took a bleaker view. "One-fifth of European banks are at risk of insolvency," said Jan Dehn, head of research at Ashmore, referencing the fact that one-fifth of banks fell shy of the ECB's pass mark at the end of last year.

He added that the ECB's efforts to boost the euro zone's sluggish growth through pumping money into the economy would not work if banks were too poorly capitalized to lend.

After the ECB adjusted banks' capital ratios to reflect supervisors' assessments of banks' asset values, 31 had core capital below the 10 percent mark viewed by investors as a safety threshold, while a further 28 had ratios just 1 percentage point above.

"(The results were) positive for equity, fundamentally disappointing on credit due to limited capital raising," Societe Generale strategist Kit Juckes noted.

Banks need to lend more to boost their earnings, since they profit from the difference between the ultra-low rate they can borrow money at and the higher rate they charge to customers. Lending can also boost economic growth, which helps banks.

Analysts from Citi remarked that the scale of the asset quality review adjustments "matter in terms of future potential regulatory constraints". Banks with big hits to capital ratios as a result of the ECB's adjustments will have less capacity to expand, lend more, or pay dividends.

Others found a silver lining in the bad news delivered by the ECB. "We were positively surprised at the severity of the asset quality review, the scale of the additional non-performing loans for example," said Roberto Henriques European credit analyst at JPMorgan. "That additional information showed that they are going to be much more stringent."

Several also welcomed the fact that investors at least now had transparent figures they could rely on. "This should ease any concerns about more skeletons the banks' closets," said Geir Lode, head of Hermes Global Equities. "(It's) positive for the markets."

That extra information gives investors some protection if the ECB's relatively modest capital demand proves not to be the final word in how much the banks really need. "Everyone will be looking hard to decide whether the ... is too little to shore up the banks that are at risk," said Salman Ahmed, global fixed income strategist at Lombard Odier Investment Managers.

"The good news is that the review process is fully transparent. Investors have been handed plenty of data on the banks' assets and are now in a position to judge for themselves."