Sustaining the turn in European banks during August 2011 has so far been difficult. Premised on clearly unmanageable risk from Spain and, even more unthinkably, Italy requiring bail-out assistance, EU leaders appear unmoved or unwilling to take cohesive or meaningful action. The result over the last three months, is a European bank sector under-performing by at least 15% vs. European and world markets.

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The heart of the issue remains the two-year EU sovereign debt crisis. A patch-work of solutions to date has yielded dismal results mainly because they do not meaningfully reduce debt burdens. This is now being undermined by weakened economic growth across the eurozone, including Germany, the U.S. and increasingly previously stable emerging markets.

This is adding further stress to weaknesses in the European banking system. The start-stop purchase of bonds by the ECB has been confusing. The sector’s dependence on wholesale markets leaves it exposed to funding uncertainty and balance sheet strain. Distrust among banks is rising evidenced by growing balances on deposit at the ECB and sharp upward trend of the LIBOR-OIS spread* since August. Unlike their U.S. peers, European banks did not raise substantial capital during the sub-prime induced crisis and the capital position of most remains weak under Basel III standards. Unwinding of excess real estate lending in a number of economies has raised loan loss provisions. Weakening economic activity will further exacerbate this, simultaneously worsening loss trends for the rest of the loan book, both adding to further capital shortfall.

The risk of Spain and Italy requiring bail-out funds should have been sufficient impetus for a solution, in turn easing European bank sector stress, not only because sufficient resources are not available. Addressing this risk would be sensible, but national processes with differing objectives and timetables have stymied attempts. In its current format, the EU as a group seems paralyzed instead of putting forward stronger action.

From an investment perspective, re-visiting European banks is increasingly too early. Over the last three months, the under-performance of European banks vs. U.S. and emerging market (EM) peers has widened. Recent concerns of weak growth spillover effects into EM economies has weakened EM bank performance. While the German constitutional court’s decision on bail-out funds is important, substantial consensus on key issues remain to be reached. The continuing expansion of weakness demands stronger and substantial actions that have thus far eluded decision-makers. In the interim, European domiciled banks such as HSBC (HBC) and Svenska Handelhanken (SHBA SS) offer solid franchise exposure and balance sheet strength with more limited downside.