Whither Europe’s Banks after the Stress Test?

by Jacob Funk Kirkegaard | October 29, 2014

The new comprehensive assessement of the European banking sector—including the “stress tests” of banks—was released in late October and made headlines by highlighting progress toward solvency and health in the banking system. But the tests also underscored concerns that many banks will need more capital and a more profitable business model to survive in the future.

By itself, the comprehensive assessment is unlikely to spur growth in the euro area, though some financial market fragmentation should be eased. Accordingly, the comprehensive assessment will prove a necessary but not sufficient exercise to restore sustainable growth and job creation.

The comprehensive assessment [PDF], carried out by the European Central Bank (ECB) and the European Banking Authority (EBA), had two parts—an asset quality review (AQR) to examine and ensure that the valuation of assets on banks’ balance sheets is correct and according to uniform standards, and a stress test to see if the banks are sufficiently robust to survive a further deterioration of the euro area economy. The test found that 25 banks failed the two-part financial health check for a total capital short fall of €24.6 billion. Of this figure, €11.2 billion came from the stress test component of the comprehensive assessment, €10.7 billion came from asset revaluations, and the last €2.7 billion from asset valuation changes incorporated into the stress tests.

Because some banks had raised capital already in 2014, only 14 banks were found to have had a capital shortfall. They must raise €9.52 billion to satisfy the supervisors. Banks raised €57.1 billion euros after January 1 and before the October 26 stress deadline, and more than €200 billion since 2008. Several important conclusions follow the review.

First, all the failing banks are in the euro area, as opposed to EU countries with their own currency, posing a major challenge for the euro area and its new supervisor, the ECB.

Second, the ECB seems technically and administratively ready to take up its new tasks as banking regulator for the euro area on November 4, only two years after it was designated as the single banking supervisor by European leaders. A repeat of the Dexia and Bankia fiascos in 2011 and 2012, in which they were given a clean bill of health only to collapse just a few months later, seems unlikely. A good grade by the ECB can generally be more trusted as immune to political pressure from well-connected banks and their previous national supervisors.

Third, while most bearish scenarios for euro area banking may be dispelled, a period of bank equity market volatility may occur as investors digest the new financial information about the banks. Banks that failed the comprehensive assessment may not survive as euro area governments resist putting cash into them in the absence of a crisis. Beyond the 25 banks that failed the test, other banks face difficulties because the asset quality review forced them to acknowledge their exposure to €135.9 billion in nonperforming loans (NPLs) and write down their assets by €47.5 billion. As mentioned above, only €10.7 billion of this sum was uncovered in banks that failed the comprehensive assessment, leaving around €37 billion of these asset write-downs to be recognized on the books of other euro area banks in the coming quarters. The ECB must now aggressively require banks to recognize these losses.

Fourth, no banks in the euro area were deemed unviable and required to shut down, in part because two tested banks—Banco Espirito Santo in Portugal and Volksbank in Austria—are already being restructured. But the ECB’s willingness to force such closures or restructuring free of political interference in the future remains unknown.

Fifth, the comprehensive assessment was another step in the 5-year process of resuscitating the European banking system, in which each stress test has become gradually tougher. The comprehensive assessment highlighted two areas where pressures might build on banks that passed the stress test.

The first issue relates to the definition of capital in the latest review. International banking authorities have agreed to introduce a new definition of capital for banks to be applicable in 2017. Although this new standard—known as the “fully loaded Common Equity Tier 1 (CET1) ratio” —was not part of the comprehensive assessment, the comprehensive assessment published the data so that financial markets can apply the standard to more fully understand the future state of euro area banks. The CET1 standard is much tougher on banks, as it excludes various lax interim arrangements and accounting standards used by banks before they adopt the new standard. The most notorious of these is the ability of banks to employ what are known as deferred tax assets, which enable the banks to inflate the amount of risk capital they have with what has in many cases been essentially a government fiscal transfer to the banks through the backdoor. The effects of these shenanigans in the comprehensive assessment were to let banks avoid having to add €126.2 billion in new capital to get to the new CET1 standard. Were they to have to add that amount, many more banks would have failed the test. German banks benefitted the most from these issues by €33 billion. Spanish banks get away with not having to add €25 billion in new capital, and Italian banks, €16 billion. The fully loaded CET1 data, which is provided for the adverse scenario for the year 2016, better indicates how banks will fare as the new supervisory rules come into force.

Traditionally, banks have used risk-based ratios for their assets, setting aside less capital to cover potential losses on for instance good standard mortgages than a subprime car loan. International banking authorities—the Financial Stability Board/Basel Committee—are calling for a phase-in of an unweighted leverage ratio, which ignores all risk-weights to bank assets and simply measures the straight ratio between a bank’s assets and its capital. A 3 percent leverage ratio is supposed to come into force by 2018.

Figure 1 shows the data for those euro area banks that are close to the 5.5 percent limit on a fully loaded CET1 basis in the adverse scenario in 2016 and had a leverage ratio close to 3 percent, following the effects of the asset quality review. The size of bubbles in figure 1 illustrates the size of the bank’s balance sheet, and yellow banks had capital shortfalls under the comprehensive assessment’s definition of capital.

Figure 1 Euro area banks: Fully loaded CET1 ratio, adverse scenario 2016 and post-AQR leverage ratio

Figure 1

AQR = asset quality review; CET1 = Common Equity Tier 1
Note: Data for all euro area banks for which both fully loaded CET1 and post AQR adjusted leverage ratio is available can be downloaded here [XLSX].
Sources: European Banking Authority [PDF], European Central Bank [ZIP]

Figure 1 illustrates how under a fully-loaded CET1 capital definition (Y-axis), many more banks would have failed the comprehensive assessment, including noticeably several German banks like WGZ Bank, DZ Bank, HSH Nordbank, and LBBW (at 5.47 percent). Four more Italian banks would also have failed, as would two Austrian, a Spanish, a Belgian, a Dutch, and an Irish bank. Thus many more banks beyond those that failed the stress test are likely to need new capital under the new rules. Unless markets and the ECB put pressure on these banks quickly, they risk becoming the new euro area zombie banks. At a minimum, shareholders in these banks should probably not expect any large dividend payments in the coming years.

Figure 1 also highlights how some other euro area banks—noticeably the giant Deutsche Bank—will face trouble in adhering to a 3 percent leverage ratio (X-axis). Were the leverage ratio to be increased from 3 to 4 percent, a number of very large Dutch and French universal banks would also be affected.

These data, published in conjunction with the comprehensive assessment but not part of the actual review, reveal the vulnerabilities in the euro area banking system well beyond the 25 failed banks. Forward-looking bank equity markets will likely force these banks to raise more capital, with the encouragement of the new ECB supervisor.

As it takes over as the competent supervisor, the ECB has the legal authority to end many of the differences between the comprehensive assessment capital definition and the fully loaded CET1 definition in figure 1. It could do so without delay and move to quickly end the distortive effects of national Basel 3 phase-in schedules and eliminate the usage of deferred tax assets (DTAs) as bank capital in the future.

As the ECB notes in its aggregate report (p. 137), even deferred tax assets that do not rely on future profitability reduce the need for new capital and create new liabilities for the government, increasing the potency of the doom-loop between banks and their national government that the banking union was supposed to end. If euro area governments want to inject capital into the banks, let it be real capital. Let such aid adhere to the EU state-aid rules and be defended in front of taxpayers, rather than be backdoor “silent participation” of governments in their banks’ capital structure.

Copyright 2014 the Peterson Institute