What was released?
The weekend saw the release of two linked, but distinct, assessments of European banks. In one the European Banking Authority (EBA) conducted a stress test for 123 banks in the EU. The second report was from the European Central Bank (ECB) as it conducted an asset quality assessment of 130 banks in countries inside the Eurozone (including Lithuania which joins the Euro next year).
What’s the difference between the two?
Under the stress test the EBA examined banks ability with withstand adverse economic developments. During the last recession too many banks came up short, with the losses from loans either exceeding their capital or depleting it to below a safe level. The stress test tries to ensure that banks are adequately capitalised by seeing how the balance sheet of banks react to another recession. Roughly they assumed a 2.2% decline in GDP in 2014 rising to a cumulative 7.0% by the end of 2016 with corresponding effects on unemployment, property prices etc.
For the asset quality assessment the banks had to review their loan books to standards set by the ECB – the report cites 800 specific portfolios representing 57% of the banks risk-weighted assets. Essentially the ECB is checking the banks over before it takes over supervision of them next month. In some ways this could also be seen as an assessment of how strict national regulators have been.
There was also a slight difference in scope, so the list of banks in each report was not identical. For example UK banks were subject to the stress test, but not the asset quality review.
So what were the results?
(1) Asset Quality Review: This can be seen as rebasing the starting point (as at 31/12/13). In aggregate there was €47.5bn of asset write downs with non-performing loan exposure increased by €135.9bn. To give some context that is 4.8% and 13.9% of banks aggregate available capital. The interesting part, of course, is that is not spread evenly. Perhaps unsurprisingly Greece and Cyprus see the biggest proportionate adjustment with Italy largest in absolute terms. Gold stars go to France and Spain, the latter not being a real surprise as the Bank of Spain has a reputation as a good regulator despite the country’s economic problems.
(2) Stress Test: Under the adverse scenario the capital available to banks would be depleted by €215.5bn, 22% of the total available. The projected growth in risk-weighted assets by 2016 brings the total impact up to €262.7bn. This is equivalent to the median banks core tier 1 ratio (CET1 = capital / risk weighted assets) being reduced from 12.0% to 8.3% in 2016, comfortably in excess of the minimum of 5.5%.
Averages lie – who really suffered?
Although the average bank did ok, 25 of them had capital below the 5.5% minimum under the adverse scenario meaning they would have to raise capital to cover the shortfall. Now this was as of last 31st December and several had already done so, reducing the aggregate shortfall from €24.2bn to €9.5bn. Italy had the largest amount, with nine banks on the original list and four remaining after fund raisings. The one that got the headlines was Banca Monte dei Paschi di Siena, one of the world’s oldest banks, which needs €2.1bn. There are also a couple of Greek banks and BCP in Portugal which in aggregate account for over half the residual.
Can we believe the results?
Probably. The stress test is now an annual occurrence and there have been concerns that previous ones have not been strict enough. In terms of the economic scenarios and the rigorousness this test appears to be more credible than the previous ones, but caveats remain.
The first is tax credits in capital. Due to the losses over the last few years many banks have capitalised losses that they can offset against future tax. These are a valuable asset, but depend on the generation of future profits and are clearly worth less than their face value. And they can be counted towards capital in Europe. This is being phased out, but only by 2023. According to the <a href=“http://online.wsj.com/articles/ecb-should-show-regulatory-mettle-on-bank-capital-heard-on-the-street-1414407809”>Wall Street Journal</a> this represents 40% of Greek bank capital and even 10% in Germany. While this is much lower than Japanese banks in the 1990s, it is still a concern. If the banks tried to sell the credits they would not get anywhere near face value.
The second is the progression towards the Basel III capital requirements. This is a much stricter regime than before and the EU has adopted a transitory arrangement, allowed a gradual move towards the new number. To give some idea Lloyds, who issued a trading statement today, would see its CET1 reduce from a current figure of 12.0% to 4.7%. The report outlines the figures in its appendices and they aren’t pretty. Now the idea of relying implementation towards the end of the decade was to allow bank profits to boost the capital coffers. But that effectively assumes that banks can maintain profitability, which requires no more economic problems.
How much do these results matter?
For the shareholders of banks they matter hugely, particularly those who have to raise more capital and are likely to see themselves diluted. Most of the names come as no great surprise though, so perhaps it is difficult to have sympathy for them.
For the rest of us the answer is not so much. It has been clear for some time that as a whole the European banking system was recovering. We’ve seen banks return to the lending markets over the last couple of years – UK property companies, for example, basically said that banks reopened their doors 18 months ago. There has been much discussion if the lack of lending was banks restricting supply or borrowers lacking demand. The former should not be a problem now, now we need the latter to return.