02 August 2010

Europe’s banks stress test: not really stressful…

Whilst the ECB was first and foremost to react to the hedge fund collapse of Bear Stearns and BNP Paribas during August 2007, Europe has been running behind events ever since. Within the EU, the recent June decision to screen the main EU banks risk/capital adequacy and publish the findings was taken on the back of a unilateral decision by Spain following the seizure of its banking sector in June.
Being behind events does not mean that the exercise is not useful if properly conducted, whilst its main aim was for policymakers to calm down the markets. I am not going to review at length the criteria used, since the claimed transparency is somewhat tainted with opacity.
Scope of the test
The stress test was conducted on 91 European banks in 27 countries representing 65% of the total assets of the EU banking sector or EUR 28 trillion, which is representative enough.
It covers 2010 and 2011 and mainly focuses on credit and market risks.
Banks pass the test if their Tier one capital over their risk weighted assets reaches a 6% threshold (the regulatory minimum Tier one capital in Europe is 4%).
Adverse macro-economic scenario
The assumptions concerning GDP growth are no so adverse: a 2% drop in GDP over 18 months doe not cry foul, particularly if countries outside Europe see their growth decrease significantly (a real possibility in the US a possibility in Asia). However, I can live with this. As I do with the assumption concerning a 175 basis points hike for 3 months rates and 75 basis points for 10 years by the end of 2011, even if in case of crisis these would most likely head north and fast.
Sovereign debt
The haircut applied to sovereign debt is not appropriate: it is not a question of taking off, 10% here, 2% there and 4% elsewhere. It is a binary game: a country defaults or not; in case of default the haircut will be much larger than the ones assumed in the CEBS analysis. Again, I can live with this.
Where things are becoming questionable is the treatment of sovereign debt in banks books. A cut is applied to the trading book whilst none is for the “investment” book; I must admit that the difference is quite specious: either a country can default or not and any investment would be affected. European policy makers said that there no way that any European country will be allowed to default; well, they also said that the euro would enhance economic growth and protect European citizens (the famous fortress Europe - like the Maginot line of defense)... In addition, if only 7 banks have to quickly raise EUR 3.5 billion of equity, 17 banks have a ratio comprised between 6 and 7% (including Deutsche Bank, the largest German bank which may explain why Germany refused to publicize details of the sovereign debt books of German Banks).
As stated by the CEBS report:
In total, aggregate impairment and trading losses under the adverse scenario and additional sovereign shock would amount to 566bn € over the years 2010-2011.
The aggregate Tier 1 ratio, used as a common measure of banks’ resilience to shocks, under the adverse scenario would decrease from 10.3% in 2009 to 9.2% by the end of 2011 (compared to the regulatory minimum of 4% and to the threshold of 6% set up for this exercise). The aggregate results depend partly on the continued reliance on government support for currently 38 institutions in the exercise.
The aggregate Tier 1 ratio incorporates approximately 197bn € of government capital support provided until 1 July 2010, which represents 1.2 percentage point of the aggregate Tier 1 ratio.
So the picture looks rather rosy with plenty of cushion…
However, beyond affirming that no European country will allowed to default (saying otherwise would trigger a new rout on banks and the euro) does not mean that it could not occur (please note that I do not believe that a EU country – at least any eurozone country – will default straightforwardly, but I do believe that a rescheduling of debt is on the cards GDP growth failing to deliver enough to service it which according to my simulations is at least true for Greece). To conclude, trading books were tested and cleared from a double-dip recession – not the complete balance sheet impact of a sovereign debt default was analyzed.
There are at least two additional questions: 
  • Did the study take into account rating downgrades that would require banks to match their assets with more capital?
  • There is no test taking into account core capital only; banks have used financial engineering to boost their Tier one capital ratios instead of core equity to enhance their return on equity. In my opinion core equity is the real parameter to take into account to test bank’s stress conditions.
After a mild reaction on Monday 26th July, banks shares showed strong gains, particularly in the eurozone and this continues today (August 2nd). This has however probably more to do with the Basel Committee on Banking Supervision that moderated several of its planned rules that would have required more capital and increased costs for banks on the very same Monday. In the meantime, CDS 5 yr spreads across Europe went down between 20 et 50% since June peak. Accounting rules also remain accommodating.
To conclude, the stress tests fulfilled their objective short term to calm markets; longer term, the fundamentals of Greece and several other European countries with structural budget deficits and subdued growth are not properly addressed. This will come back to the forefront of market concerns in the coming 12 months. Meanwhile, I will closely follow the progress of the Greek stabilization plan and GDP growth.
Committee of European Banking Supervisors (CEBS): Aggregate outcome of the 2010 EU wide stress test exercise coordinated by CEBS in cooperation with the ECB
FT: Triple bonus boosts Europe bank shares