Were The EU Bank Tests Stressful Enough?


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On 23rd July the results of the much anticipated stress tests on European banks were published. There were no surprises, with just seven out of the 91 banks tested across the 27 EU Member States

On 23rd July the results of the much anticipated stress tests on European banks were published. There were no surprises, with just seven out of the 91 banks tested across the 27 EU Member States failing. But does this mean that European banks are safely out of the woods? While the results will hopefully give the markets more confidence, there are concerns that the tests were too lenient.

The stress tests were carried out by the Committee of European Banking Supervisors (CEBS) in close cooperation with the European Central Bank (ECB). They tested Tier 1 capital ratios (the percentage of a bank's equity capital to its risk weighted assets and a common measure of a bank?s resilience to shocks) under a benchmark scenario for 2010 and 2011.

The aim was to assess how resilient the EU banking system would be to another economic downturn and to what extent banks could absorb adverse movements in the sovereign debt and credit markets.

The regulatory minimum for Tier 1 capital is 4%, but for the purpose of the exercise it was set at 6%. Tests were carried out for the two-year period ending 31st December 2011 for an adverse scenario assuming a 3% deviation of gross domestic product for the EU compared to the European Commission?s forecasts cumulated over the period.

The seven banks whose Tier 1 capital ratio fell below 6%, with a capital shortfall of ?3.5 billion, were Germany?s Hypo Real Estate, Greece?s ATEbank and five regional savings banks in Spain (Unnim, Cajasur, Diada, Espiga and Banca Civica).

There has been widespread criticism that the conditions were too easy.

A commentary released by Aberdeen said: ?Arguably more banks would have failed had the CEBS adopted more strenuous modelling. Rather than a 3% deviation in the EU?s growth forecast they could have factored in a greater than 5% double-dip. Furthermore the CEBS assumed no sovereign default, with the worst case scenario a 23.1% haircut on Greek sovereign debt.?

Other analysts believe a 7% Tier 1 capital radio would have been a more credible benchmark. In this case Allied Irish Banks, Germany?s Postbank (one of its largest), Italy?s Monte del Paschi, Portugal?s Espirito Santo and Greece?s Piraeus would all have failed.

Credit Suisse pointed out that the tests based just on core Tier 1 would have been a more reliable test ? and would resulted in the whole of the Greek banking system, plus many other lenders, failing.

The tests also assume that all States would contract at the same rate in a downturn, whereas the ?Club Med? states and Ireland would probably contract more if a downturn comes on top of their current fiscal tightening and debt-leveraging.

According to research by the Royal Bank of Scotland (RBS) at the end of May, Greece, Spain and Portugal had issued public and private debt worth ?2.16 trillion between them, equating to 22% of the region?s gross domestic product.

Other responses to the stress tests were most positive. In its half yearly global outlook the Bank of America said they marked the ?beginning of a return to normality?, with its chief European economist commenting: ?Greece is staging an impressive fiscal turn-around. Spain has come through its July peak funding with flying colours. Europe can and will get its problems under control.?

Aberdeen?s communication concluded by saying that the European banking system appears reasonably well placed to withstand a conventional downturn? but the results tell us little about how banks would cope in more extreme scenarios. It called for greater disclosure by banks on the nature of their asset bases and liquidity profiles to help foster confidence in the banking system.

Confidence in European banks will not have been helped by an article entitled ?Europe's ?30 trillion headache? published in The Telegraph on 29th July.

The article covers a new report by rating agency Standard & Poor?s (S&P) which reveals that European banks have amassed ?30 trillion in liabilities and face a serious funding threat over the next two years.

With European banks, most of their mortgages and personal loans remain on their balance sheets and need funding. The three month loans offered by the ECB?s emergency lending effectively concentrated roll over risk for large amounts of debt. Banks will eventually have to refund these loans in a crowded market. S&P commented: ?ECB loans have contributed to a shortening of liability maturities. The result is a growing funding mismatch for the European banking industry. This is happening as regulators prepare to introduce tougher liquidity standards. This is one of the greatest vulnerabilities of the industry?.

Around ?1 trillion of debt in the Eurozone and Britain will become due by 2012. The stronger banks will cope, but what about the weaker ones?

Silvio Peruzzo from RBS told The Telegraph: “If down the line the markets start to question the debt trajectories of [Club Med] countries, the banking systems will be tested again. There is ?1 trillion of private debt in Spain linked to just one asset: property.

In its Financial Stability Report at the end of May, the ECB had also warned that Eurozone banks are now experiencing a second wave of writedowns. It predicted that they will suffer loan losses amounting to ?195 billion over 2010 and 2011 – on top of the ?238 billion written off in bad debts by the end of 2009.

None of this necessarily means that there will be more bank failures in future ? but nor should we rule the possibility out completely. The European banking industry is not out of the woods yet.

Whether it is your bank accounts, insurance policies or your investments, you should always establish to what extent they are protected in the event of institutional failure. When it comes to your investments, try to use arrangements whereby your assets are not held on the institution?s balance sheet. This way your assets are segregated from potential creditors of the institution, giving you peace of mind that your capital is protected.

Seek professional advice from an authorised advisory firm such as Blevins Franks Financial Management Ltd on the arrangements which would provide the highest security for your wealth.

By Bill Blevins, Managing Director, Blevins Franks

30th July 2010

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