A new research put out by Deutsche Bank AG (USA) (NYSE:DB) (ETR:DBK) shows the gloomy condition of European banks. The economy is worsening, bad debt expectations are on the rise, deposits fell 1.5 percent during the second quarter, and the loan balance forecast to decrease 1.6 percent. Overall, says Deutsche Bank, 2013 looks like a tough time for the entire European banking system.

Banks

Deutsche Bank AG (USA) (NYSE:DB) (ETR:DBK) found that the aggregate earnings were down 6 percent during the second quarter. Of the 32 banks included in the research, 27 witnessed negative EPS momentum while only 5 experienced earning upgrades. So, the downgrade to upgrade ratio was 5:1. The negative EPS momentum was primarily because of the increasing bad debt charges and lack of cost response.  As of mid-August, European banks were trading on 0.7x 2013E PTBV, and 7.3x 2013E adjusted EPS, far below long-range averages but at the 12 month mid-point.

European banks price to book value historic data

The low interest rates put pressure on the interest margins on the liability as well as asset side. On the asset side, the high yielding assets are running off, while on the liability side, the banks are losing margins on the low or zero yielding deposits. However, the low interest rates alone are not responsible for the reduced earnings. The biggest contributor to lower earnings, was bad debt, which rose from 76 billion euros to 81 billion euros.

The poor second quarter earning trends made the selection of stocks difficult for Deutsche bank. It’s high time ECB must intervene, otherwise the imbalances may go out of control. Deutsche Bank AG (USA) (NYSE:DB) (ETR:DBK) thinks that the economic outlook is likely to remain tough irrespective of the ECB actions. The recommended picks are Swedbank AB (PINK:SWDBY) (STO:SWED-A) and Lloyds Banking Group PLC (NYSE:LYG) (LON:LLOY) – both are outside of the Eurozone. Within the Eurozone, BNP Paribas SA (EPA:BNP) is the best bet, as Deutsche Bank thinks its valuation is far too cheaper. Credit Suisse Group AG (NYSE:CS) has been upgraded to Buy rating as its franchise is super strong in the areas it is present.

Here are the top picks of Deutsche Bank:

Stock                                                     DB Rating                                                 Price  (CHF)                                   Target Price (CHF)

BNP Paribas                                             Buy                                                                 35.2                                                        42

SwedBank                                                  Buy                                                                  121.4                                                      123

Credit Suisse                                            Buy                                                                   18.2                                                        23.0

Lloyds Banking Group                             Buy                                                                   34.8                                                        53

The biggest risk to all the four picks remains the inaction of ECB that may pose systemic threats. If that happens, the prices may decline as much as 40 percent, as per Deutsche Bank estimates.

Another problem for the European banks is funding. In the firs half of 2012, the European banks issued debt worth 481 billion euros, while the maturing debt is estimated to be 831 billion euros. The shortfall was supplied by ECB. Due to the rising difference between issuance and maturities, the European banks are increasingly using the ECB funds, and now the ECB has reached its limits on government guaranteed bank debt.

The banks are also finding it hard to raise the deposits but their efforts haven’t been successful in the current economic scenario. Now all hopes are on ECB to prevent the expatriation of funds so that more money could be deposited in the ailing banks.

In Part II we will look more in depth at Credit Suisse Group AG (NYSE:CS).