EU Banks: Stressed or Not Stressed

July 30, 2010

The much-awaited EU banking stress test results were released with much fanfare last
Friday. The tests revealed that the European banking system is relatively well-capitalised
and capable of weathering adverse shocks stemming from either a double-dip recession
or elevated sovereign risk. Financial markets responded well to the results, though the
entire process has been derided by many analysts as a sham. The amount of disclosure
and transparency was a welcome surprise, but the test itself was not particularly stressful,
and as a consequence, the results are likely to be only a small step in returning the
interbank market to normalcy.
The stress tests were conducted by the Committee of European Banking Supervisors
(CEBS) in conjunction with the European Central Bank (ECB) and national supervisory
authorities; the test was applied to 91 European financial institutions from 20 countries
that combined represent roughly two-thirds of the EU’s banking sector. Just seven
institutions failed the test, including five Spanish savings banks, Germany’s Hypo Real
Estate, and the Agricultural Bank of Greece. The number of stress test failures fell well
short of expectations, as too did the cumulative capital shortfall at just €3.5 billion, which
begs the question – was the exercise far too lenient?
The test utilised macroeconomic assumptions that appear both reasonable and relatively
stern. The adverse scenario envisages a double-dip recession, with EU GDP contracting
by 0.2 per cent in 2010 and 0.6 per cent in 2011, as compared with baseline growth of 0.7
and 1.5 per cent respectively. This may not appear to be particularly severe given a GDP
decline of more than four per cent in 2009, but it implies a cumulative output loss of
roughly six per cent over a three-year period, which is sufficiently pessimistic on any
measure.
The country-specific stress test assumptions for both commercial and residential property
prices are relatively severe under the adverse scenario. The Spanish for example, assume
a cumulative decline of 38 per cent for commercial property prices versus the baseline
that already assumes a significant price drop over the two-year period. The Germans
assume a cumulative decline of more than 20 per cent for both commercial and
residential property prices, even though the country never experienced an asset bubble.
So far so good, but unfortunately that’s as good as it gets. The adverse scenario for
elevated sovereign risk included haircuts on 5-year bonds at the end of 2011 of 23 per
cent for Greek bonds, 14 per cent for Portuguese bonds, 13 per cent for Irish bonds, and 7
per cent for Italian bonds. These haircuts however, are applied only to the banks’ trading
books, which are marked-to-market, and not to their banking books, where securities are
assumed to be held to maturity. This seriously undermines the credibility of the test
because the vast majority of sovereign bonds are held in the banking book, and would
only suffer a write-down if there was serious doubt about an issuer’s ability to repay.
Thus, the test simply dismisses the possibility of a sovereign default, even though market
prices suggest that the probability of a Greek default is close to 30 per cent.
A further criticism is the tests’ focus on Tier 1 capital rather than common shareholders’
equity. Tier 1 capital includes both common shareholders’ equity and hybrid capital,
which combines features of both debt and equity. Hybrid debt instruments were issued in
substantial amounts by European banks during the credit bubble, as a means to leverage
their balance sheets without a detrimental effect on their credit ratings; hybrid debt
instruments have also formed part of governmental support for the banking sector in
several EU countries. Given hybrid capital’s debt features that include a fixed payment
stream, it is a questionable measure of strength, and had the stress test focussed solely on
shareholders’ equity, it is quite probable that the list of failing institutions would have
been substantially larger than the seven banks reported. Indeed, all of the German
Landesbank passed only because of the use of the wider definition of capital.
The stress tests did surprise with the level of disclosure and transparency, particularly in
the case of the Spanish financial institutions. The Germans however, continue to drag
their feet and adopt a contemptuous attitude that was apparent from the outset. Of the
seven banks that have not disclosed their sovereign bond holdings, six are from Germany
including Deutsche Bank, Deutsche Postbank, DZ Bank, Hypo Real Estate, Landesbank
Berlin and WGZ Bank. This is obviously disappointing and one wonders what the five
German institutions that passed the test are attempting to conceal.
The EU banking stress test is clearly a step in the right direction, but the low failure rate
and aggregate capital shortfall confirms that the confidence-building exercise is less than
convincing. The inclusion of a possible sovereign debt default was always a political
non-starter, but the deliberate omission of such a credit event undermines the test’s
credibility, while the use of a questionable definition of capital yields the estimated
financing requirements unreliable. All told, the not-too stressful test is unlikely to result
in a significant easing of strains in the interbank market.

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The views expressed are expressions of opinion only and should not be construed as
investment advice.
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