The Stoxx Europe 600 Bank Index, which tracks the performance of Europe’s largest listed banks, closed the week down 8.7% as European banks were hammered jointly by investors, credit rating agencies and, perhaps most worryingly, depositors. Conversely, specialist short ETFs that track this index inversely, such as the DB X-trackers Stoxx Europe 600 Banks Short Daily ETF, rallied strongly.

ETFs such as the DB X-trackers Stoxx Europe 600 Banks Short Daily ETF have rallied strongly on credit rating downgrades and news of depositor withdrawals.

The news that savers had been withdrawing cash en masse at a number of Greek and Spanish banks proved particularly destabilising for the sector, as was the previous week’s news that Bankia, one of Spain’s largest banks, was the subject of an emergency bailout and part-nationalisation by the Spanish government.

The state of banks across the whole of Europe isn’t great, but the situation in Spain, Italy and Greece is particularly acute, as recent credit rating downgrades reflect. During the week, a total of 16 Spanish and 26 Italian banks were downgraded by Moody’s, as well as 5 Greek banks by Fitch.

In explaining its decision on Spanish banks, Moody’s highlighted four main drivers, including i) adverse operating conditions, characterised by the renewed recession, the ongoing real-estate crisis and persistent high levels of unemployment; ii) reduced creditworthiness of the Spanish sovereign, which affects the ability of the government to support banks; iii) rapid asset-quality deterioration, with non-performing loans to real-estate companies rising rapidly; and iv) restricted market funding access, with the ongoing eurozone debt crisis contributing to persistent investor concerns.

Moody’s assessment of Italian banks was a similar story. Specifically, the agency cited i) increasingly adverse operating conditions, with Italy’s economy back in recession and government austerity reducing near-term economic demand; ii) mounting asset-quality challenges and weakened net profits, as problem loans and loan-loss provisions are rising; and iii) restricted access to market funding.

It was much the same for Greek banks. The downgrade of five by Fitch, including the country’s oldest and largest commercial bank, National Bank of Greece, reflected the dramatic spike in uncertainty following the country’s recent parliamentary elections and subsequent collapse of coalition talks.

The analysis from Fitch is that in the event that the new general elections (scheduled for 17 June) fail to produce a government with a mandate to continue with the EU-IMF programme of fiscal austerity and structural reform, an exit of Greece from the eurozone would be probable and this could be followed by a withdrawal of international support to Greek banks. A Greek exit would likely result in widespread default on private sector as well as sovereign euro-denominated obligations.

Overall, several mitigating issues have limited the magnitude of the bank downgrades for all three countries, the most notable of which has been the substantial liquidity support from the European Central Bank (ECB), thus significantly reducing near-term default risk.  However, the outlook for European banks remains negative.

For investors wishing to hedge their European banking-sector exposure over the short term or speculate on continued weakness, they could consider the DB X-trackers Stoxx Europe 600 Banks Short Daily ETF from Deutsche Bank or the Lyxor ETF Stoxx Europe 600 Banks Daily Short from Lyxor, part of Societe Generale. Both of these funds provide inverse/short exposure to the Stoxx Europe 600 Bank Index, which tracks banks in Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, the UK and Iceland.

Over the past three months these ETFs, which deliver negative exposure to many of the banks downgraded, have rallied over 25%.

Both products are synthetically created (swap-based) and reset on a daily basis, meaning their performance can diverge from the underlying index over time. However, these ETFs would be expected to perform well should the situation within the eurozone deteriorate further. Indeed, from mid May 2008 to early March 2009, the worst performing period for listed European banks on record, the DB X-trackers Stoxx Europe 600 Banks Short Daily ETF delivered a return of over 185% (see chart below) (the Lyxor ETF wasn’t launched until 2010).

But a word of caution, short/inverse ETFs are specialist short-term investment tools and investors should fully understand and consider the suitability of these products before making an investment.

DB X-trackers Stoxx Europe 600 Banks Short Daily ETF (TER 0.50%)
London Stock Exchange (LSE) (XS7S)
Xetra  (DXS8)
Borsa Italiana (XS7S)
Euronext Paris (XS7)
NASDAQ OMX Stockholm(XS7S)

Lyxor ETF Stoxx Europe 600 Banks Daily Short (TER 0.45%)
Euronext Paris (BNKX)
Xetra  (LYQ9)
Borsa Italiana (BNKX)
SIX Swiss (LYBNKX)

Performance of the DB X-trackers Stoxx Europe 600 Banks Short Daily ETF