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Some benefit from fears about sovereign debt

European bank stocks have been hit; But volatile government bonds will boost earnings

While investors focus on their new obsession with sovereign risk and markets grapple with the prospect of some form of sovereign debt rescheduling in Europe, European bank stocks sank by close to 12% in the first six weeks of 2010.

As fear mounted that the contagion could spread from Greece to larger economies with high budget and/or current account deficits and high personal and corporate leverage, notably Spain and also the UK, analysts painted a bleak picture of the impact on banks from direct losses on government bond holdings – which account for on average 5% of bank’s total assets across Europe – as well as from higher funding costs and worsening asset quality if doubts about sovereign debt sustainability derail economic recovery.

Jagdeep Kalsi, analyst at Credit Suisse, says that: "In the event of a 1% decline in GDP, loan volumes falling 2%, NPLs growing 5%, bond spreads widening further and a flight to quality in currencies, we see the [European bank] sector losing nearly 50% of 2010 estimated earnings and 5% of tangible net asset value. Return on tangible equity would fall from 8.7% on our current estimates to 4.7%."

Even if such an extreme outcome is avoided and Greece shows progress by mid-March on its plans to cut the budget deficit by four percentage points, analysts are still cutting estimates for banks’ earnings out to 2011, especially for those with exposures to southern Europe.

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