This week marked a step-change in the gravity of the eurozone sovereign debt crisis as Standard & Poor's downgraded Spain and Portugal's sovereign credit ratings and the risk of contagion beyond Greece increased substantially. In that context, investors must consider the risks and opportunities a full-blown crisis presents regarding European shares and, specifically, those of banks.

Avoid European banks
In the immediate future, my recommendation would be to avoid European banks altogether. Watching European leaders trying to cobble together a rescue package for Greece has not given me much confidence that they would be able to deal effectively with contagion to the other PIIGS nations (Portugal, Ireland, Italy, and Spain). As such, I think things could get quick a bit worse before they get better. I find deep value investing as alluring as the next investor, but European bank valuations simply aren't in that territory at this stage (although we could certainly get there if the crisis worsens).

Prefer Switzerland to Spain
If you must own European bank shares at this time, among those that trade on U.S. exchanges, I would avoid the two major Spanish banks Banco Santander (NYSE: STD) and Banco Bilbao Vizcaya (NYSE: BBVA). They are at the bottom of the group regarding capital ratios, and they are not particularly cheap on a relative basis, either. At the other end of the scale, I much prefer the Swiss banks UBS (NYSE: UBS) and Credit Suisse (NYSE: CS), with a domestic market outside the eurozone and respectable looking capital ratios (tier 1 capital ratios are 15.4% and 16.3%, respectively):

Bank

Tier 1 Capital Ratio

Price/Book Value

Banco Santander

10.1

1.05

Banco Bilbao Vizcaya

9.4

1.12

UBS

15.4

1.36

Credit Suisse*

16.3

1.52

Source: Capital IQ, a division of Standard & Poor's.
*Total for 4th calendar quarter, 2009.

Thinking about a worst-case scenario
At this stage, investors can't afford to exclude the possibility of sovereign defaults in multiple Eurozone countries and a fundamental redrawing of the eurozone map. This has implications that go well beyond European financials: According to a research note by Wells Fargo, JPMorgan (NYSE: JPM) and Morgan Stanley's (NYSE: MS) exposure to the five PIIGS nations is $36.3 and $32.4 billion, respectively. While JPMorgan's total might be higher in total terms, Morgan Stanley's exposure is equivalent to more than two-thirds of its Tier 1 capital. Not exactly a thought that should leave investors sleeping soundly at night.

Europe has a real problem on its hands, but between high valuations and sluggish growth, investors can expect disappointing returns from U.S. stocks over the next several years. What's left? Tim Hanson explains how to make more in 2010.

Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. Motley Fool has a disclosure policy.