European Banks Stress Tests

07.11.14

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20% of banks failed “stress tests” conducted by the European Banking Authority to see if they are strong enough to withstand another financial crisis.

20% of banks failed “stress tests” conducted by the European Banking Authority to see if they are strong enough to withstand another financial crisis. All the major banks passed, with the results suggesting European banks are in better shape than when last tested in 2011.

The results were revealed on 26th October 2014. The tests looked at how the value of the banks’ assets, including mortgages, corporate loans and bond investments, would be affected by financial and economic shocks, and whether banks would have enough capital to absorb the losses.

This year’s tests were preceded by an asset quality review, so supervisors could evaluate whether the banks were correctly valuing their assets, and how much exposure they have to national government debt.

The stress tests then determined how banks would cope with a simulated situation where the region’s gross domestic product fell by 7% by 2016, and EU unemployment rose 2.9%. To pass, banks had to maintain a core capital ratio of 5.5% – so hold at least €5.50 in cash for every €100 of assets on their balance sheets.

Under a normal scenario, where the economy develops as expected up, banks core capital buffer should not fall below 8%.

24 banks failed, with a combined capital shortfall of just over €24 billion. The review was based on the banks’ financial health as at the end of 2013, and 10 banks have since raised capital to improve their balance sheets. This leaves 14 EU banks which need to raise €10 billion over the next nine months.

Italian banks suffered the biggest failure, followed by Greek ones. Portugal’s Banco Comercial Portugues, Cyprus’s Hellenic Bank Public Company, and banks in Ireland, Austria, Belgium, Austria and Slovenia, failed the “adverse scenario”.

Although no major banks failed, several came close. 14 only had capital ratios of between 5.5% and 7%, and could face pressure to improve balance sheets.

This includes Lloyds Banking Group PLC (6.2%) and Royal Bank of Scotland PLC (6.7%), both banks bailed out by taxpayers during the banking crisis. They will undergo a further stress test by the Bank of England.

After the banking crises in countries like Ireland, Cyprus and Spain, there were concerns that national supervisors had been too soft and often failed to detect problems. The European Central Bank therefore took over as regulator for the larger banks on 4th November 2014. The stress tests will help them establish the strength of the banks they are supervising.

While overall the exercise can be viewed as a success, some critics argue the tests were not realistic enough, and some analysts warn that the banking sector is not yet out the woods. Stephen Smith of KPMG told The Times: “Profitability remains a major issue. Their significant €879 billion exposure to non-performing loans, and the level of capital required to support those, is a particular area of concern and banks must seek to address this.

There are some key strategies for protecting your wealth.

First of all, diversification will reduce your exposure to risk. Spread your savings among different assets, as well as over funds, geographical areas, sectors etc. Relying on the fortunes of just one or two assets is very risky.

Wherever you keep your capital, make sure you understand to what extent you are protected in the event of institutional failure. We need to consider all the risks to our money and take professional advice to ensure our assets are in the best place. Bank deposits are not risk free (especially when you consider the damaging effects of inflation and low interest rates over time).

In the event of a bank failure, an EU Directive ensures that every country has a guarantee scheme which is responsible for reimbursing account holders up a set limit of €100,000 per depositor per banking group. Note that the Channel Islands and Isle of Man have lower limits of £50,000 (around €64,000).

Where possible, look to ring-fence your assets, so that there is a legal separation of your assets from the financial institution holding them.

One State in Europe, Luxembourg, provides maximum security to policyholders through its state controlled life assurance protection regime. This ensures policyholder assets are deposited with an independent Custodian Bank, and so are held entirely separate from the life assurance company’s assets. The Custodian Bank is required to ring fence client assets so that they are held off the bank’s balance sheet.

Investor protection varies across jurisdictions and products, so for peace of mind seek advice on what would be the best solution for you. With specialist advice it is possible to eliminate institutional risk at the same time as benefitting from gross roll up of income and gains within tax favoured structures in countries like Spain, France, Portugal and Cyprus.

5 November 2014

Tax rates, scope and reliefs may change. Any statements concerning taxation are based upon our understanding of current taxation laws and practices which are subject to change. Tax information has been summarised; individuals should seek personalised advice.

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