European Banks to be stress tested with a tickle stick?
Friday evening will see the eagerly anticipated disclosure of the results of the Committee of European Banking Supervisors’ (CEBS) EU-wide stress test for 91 European banks. The hope is that this will act as a trigger to unblock funding markets and prove that European banks have enough capital to lend to viable borrowers and so assist economic recovery. However, if the comments we have heard from various politicians and regulators are to be believed, the CEBS report will read more like an end-of-year primary school report than the considered and prudent view of a body of financial regulators. Nothing too bad will be said for fear of upsetting the parent (in this case the market). ..
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What’s good about the stress tests?
There are some positive factors in the stress test. Most obviously, the fact that it is happening and that, unlike in 2009, the results will be made public. In addition, it serves to advertise that considerable firepower can be deployed to support capital-light institutions – for example, the SoFFin in Germany, the FROB in Spain or even, ultimately, the European Financial Stability Fund. Other positive factors include the differentiated macroeconomic scenarios for different countries, the incorporation of ‘adverse conditions in financial markets’ (although how this is measured is elusive) and some incorporation of EU government bond-market losses
…and the bad?
Unfortunately, the above positives look set to be outweighed by a raft of negatives. Firstly, a comparison with the US stress-testing exercise, launched by the US Treasury in February 2009, is instructive. The US process took two months to complete, compared to closer to two weeks in Europe. There was clear independent verification of the results. By contrast – with the notable exception of Spain, where I believe the Central Bank is running the numbers – the European test is more of a self-marked exam. In addition, 10 of the 19 banks stress-tested in the US failed and had to recapitalise. If more recent leaks are to be believed the European ‘tickle stick’ will prompt capital raisings by fewer banks than you can count on the fingers of one hand.
Secondly, the rumoured methodology employed by CEBS, with respect to sovereign debt losses is odd, to say the least. Banks have been asked to stress sovereign bonds held in trading books only. Hence, Greek banks with over 3x their ‘core capital’ exposed to Greek sovereign debt, can sail through virtually unscathed (as almost all holdings have been reclassified from the ‘trading’ or ‘available for sale’ books to ‘held to maturity’).
Furthermore, the rumoured ‘stress’ sovereign losses are just 17% for Greek sovereign debt, 8% in Portugal and Ireland, and 5% and 2.5% in Spain and Italy respectively. If governments really do end up defaulting, and hopefully the only possible contender here is Greece, then losses will be much, much higher.
The problem is that we are moving here from the realms of the stress test to tail-risk events. This does not mean that the issue should be ignored; after all, this is part of the market’s current nervousness. However, my hope is that banks will be forced to provide clear and consistent disclosure of their sovereign risk exposures so that market participants can conduct their own evaluations, rather than simply guessing. Even if the disclosed results of the stress tests do not provide this information, banks should feel duty-bound to provide it to satisfy the demands of equity and fixed income investors.
Thirdly, I have heard no mention as to how structured credit exposures are to be treated. My worry is that they will be ignored. In the event of a material double-dip scenario, analysts will have to dust off those spreadsheets showing collateralised debt obligations (CDOs), commercial mortgage-backed securities (CMBSs) and collateralised loan obligations (CLOs), along with leveraged loan and monoline exposures. For some banks, these still remain very large relative to equity.
Finally, it seems that the benchmark capital hurdle for banks will be a 6% ‘Tier 1’ ratio. That is far too generous; the past three years have made it very clear that ‘Core Tier 1’ capital is a far more credible benchmark.
What does all this mean for European Banks?
Ultimately, banks are a leveraged play on the economies in which they operate. It is therefore imperative that we see a sustained recovery in GDP and asset prices. The CEBS stress test looks unlikely to act as a material catalyst in this regard (in its own right), other than in the following two important respects:
a) it advertises that European authorities continue to stand ready to support the financial system
b) it will hopefully force banks to produce clear and consistent disclosure of their sovereign risks This could inject renewed optimism into the market, helping to make economic recovery sustainable.
The views and opinions contained herein are those of Justin Bisseker, European Banks Analyst, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.
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