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Dismal earnings from dominant Spanish bank Santander Thursday highlight how solvency concerns in Europe are having a major effect on the performance of Canadian bank stocks.

Santander reported a 94-per-cent decline in profit and all but begged the Spanish government to accept an ECB bailout to improve the economy. Moody's has already cut Santander's credit rating in 2012 to Baa3 from A3 although management continues to reassure shareholders that the bank itself will not require a bailout.

Debtholders are hedging their bets. The cost of credit default swaps on Santander's debt, which are essentially insurance policies against the bank defaulting on their bonds, are moving wildly in accordance with the fears of the global investment community regarding the European financial system. And we are not immune – Canadian bank stocks are fluctuating right along with them.

The negative 0.90 correlation between Santander five-year credit default swaps (CDS) and the S&P/TSX Bank Index (see infographic chart) strongly indicates that Canadian banks are moving in virtual lockstep. When solvency fears and the cost of Santander CDS rise, Canadian bank stocks fall by a proportional amount.

The clearest evidence of the close relationship between Spain and the Canadian banks began on July 19. After the German Finance Minister questioned the possibility of financial aid for Spanish banks, a disastrous sovereign debt auction saw two-year Spanish bond yields jump sharply to levels the government could not afford to pay on an continuing basis. Over the subsequent five days, Santander CDS jumped 65 basis points or 15 per cent (the finances of the banks and government in Spain are deeply intertwined) and the entire Canadian bank index fell a full 1 per cent.

In theory the euro crisis should be a distant sideshow, since Canadian banks have little direct exposure to Spanish debt. However, the painful lesson from 2008 is that the world's banks are all joined through the short-term financing, shadow banking market and further, that any bank's exposure is not visible on the balance sheet where it can be tracked by investors. Canadian banks could be connected to Spanish banks through some unknown number of degrees of separation, but even if they aren't, the panic that follows a major bank failure could cause the entire banking system to grind to a halt, as it did when Lehman Brothers collapsed; it took bankruptcy lawyers months to figure out who owed what to whom.

The balance sheets of Canadian banks are safe from European bankruptcy concerns but the fallout from a major European bank failure is, as the market has learned, impossible to predict.

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