Should you buy bank shares after stress test results?

Results from the EU-wide stress tests have been released and they provide a guide as to how banks such as Barclays(LSE: BARC), Lloyds(LSE: LLOY) andRBS(LSE: RBS) could perform in an adverse scenario.

So what was involved? The stress tests were conducted in cooperation with the Bank of England and cover a three-year period from 2016-2018. They assume static balance sheets as at December 2015 and therefore don't take into account subsequent or future business strategies and other management actions. This is a notable difference between the EU-wide stress tests and the Bank of England's own versions, with the latter including the impact of cost savings, business growth and balance sheet reduction.

As a result, it could be argued that the EU-wide stress tests are of limited help in deciding whether UK-listed banks are worthy investments at the present time. Furthermore, RBS and Barclays state that the results of the EU-wide stress tests can't be used to infer outcomes of the 2016 Bank of England stress tests.

Improving balance sheets

So should we even pay attention? Yes. They're useful in showing that banks such as Barclays, Lloyds and RBS are making progress towards building improved and more resilient balance sheets. For example, the EU-wide stress tests showed that RBS's Common Equity Tier 1 (CET1) ratio under the adverse scenario fell to 7.8% at December 2017, while Barclays' CET1 ratio dropped to 7.3%. Meanwhile, Lloyds' CET1 ratio fell to only 10.1%, which is well above the minimum capital requirements.

Although the stress tests don't include a pass or fail measure, Barclays remains comfortable with its strategy to build its CET1 ratio over the medium term. This dovetails with its decision to slash dividends and means that the bank will seek to retain a greater proportion of profit within the business as it seeks to maintain a 100-150 basis point buffer above future regulatory CET1 levels.

Similarly, RBS has made great progress in improving its balance sheet in recent years, with leverage being reduced and its CET1 ratio gradually strengthening. Although there's still some way to go on this front for both banks, they're on the road to being better capitalised and less risky as investments than they've been at any point within the last decade. And with Lloyds already being above the required capital level, it appears to be in a relatively strong position.

Low valuations

Clearly, the outlook for the UK economy is highly uncertain. However, with Barclays, Lloyds and RBS trading on low valuations they appear to offer highly favourable risk/reward ratios. For example, Barclays trades on a forward price-to-earnings (P/E) ratio of just 8.3, Lloyds has a forward P/E ratio of 8.1, while RBS's forward rating stands at just 11.3. All of these figures indicate that investor sentiment is relatively weak and that there's significant upward rerating potential on offer.

Certainly, it's likely to take time for Barclays, Lloyds, RBS and the wider banking sector to come good and the EU-wide stress tests highlight that there's some way to go until the industry gets back to full health. However, progress is being made and with valuations being low, the risk/reward ratio of the banking sector holds considerable appeal for long-term investors.

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Peter Stephens owns shares of Barclays, Lloyds Banking Group, and Royal Bank of Scotland Group. The Motley Fool UK has recommended Barclays. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.