EU Bank Stress Test III: ECB has just as much to prove

Tower 42 [home of the EBA] seen whilst facing north at Bishopsgate

Where is the European Banking Authority’s HQ? In The City of London, of course.

 

Ken Odeluga, June 24, 2014, 774 words

The words “stress” and “test” signify something obvious for banks, but they’re also likely potent on a personal level for senior bankers whose banks are undergoing testing, or, in the worst case scenario, for bankers whose banks have failed.

Imagine how Citigroup CEO Michael Corbat feels.

The extent to which the tests are arbitrary or material might well be debatable, given regulatory authorities are just as much in the business of reputation management as the banks themselves.

But being the boss of the most high-profile bank to date that has ‘failed’ a stress test this side of the financial crises, might leave such a person with something to prove, to say the least.

Of course in a few months, he could be joined by others who are in the same situation, in Europe.

 Final details of plans to stress test 124 EU banks were released in April. Neither the European Banking Authority nor the ECB have highlighted any further dates ahead of release of results sometime in October; so, speculation about the outcome has been heightened.

There ought to be little mystery by now, about the process of the tests themselves. The European Banking Authority announced the latest round of testing in January; it released draft methodologies and “templates” in March and began informal discussions with banks at the same time. Final details of scenarios and methodology were released at the end of April.

Here is a roadmap and further details about Europe’s latest round of stress tests.

Whilst banks might well be resigned to the process, in-depth familiarity with details of the planned tests has sparked intense scrutiny over the capital conditions of Europe’s major banks amid a widening belief that regulators might have ‘stacked the deck’ to ensure at least one European SIFI ‘fails’ the tests. This expectation was compounded after U.S. subsidiaries of three European banking groups, in March, failed tests conducted by the Federal Reserve.

James Chappell, a banking analyst at Berenberg Bank told FT.com at the time of the release of the U.S. test results: “They have failed a big bank –Citi. The ECB will have to be willing to do the same if the market is to believe it is credible too.”

Such concerns seem to be focused around specific aspects of the European adverse stress-test scenario, especially the simulation of an international bond market collapse followed by a 7-percentage point drop in EU output over three years.

A number of analysts have questioned the validity of the scenario on the grounds that material imbalances have been created in the extent to which banks will be able fund themselves under such conditions, given that some continue to avail themselves of ECB funding from its Long Term Refinancing Operations and others will be reliant on market funding.

An additional important factor is that the tests are set against a backdrop of an unprecedented round of recapitalisations in the European sector since the second quarter of 2013.

According to Bloomberg, EUR34 billion has been raised or will be raised through new equity. Additionally, banks have raised EUR15 billion in contingent capital issuance and set aside EUR19 billion of provisions. [Note: I last checked these figures at the end of May.]

Despite misgivings about the forthcoming stress tests, a more sanguine view is that the sector is in a more robust condition than it has been at any time since the onset of the various financial crises at the end of the last decade. Whilst recognising that the ECB faces implicit questions about its credibility, proponents of the more positive view discount a political motivation behind the ECB enforcing greater rigour in the latest tests versus earlier ones.

For instance, Alberto Gallo, Head of European Macro Credit Research at Royal Bank of Scotland Global Banking wrote during a short discussion we had by email, late last month:

“I think the adverse scenario is realistic. People would not expect large banks to fail but they would like 5-10% to fail for the test to be credible. The market knows that some banks still need to raise capital, but capital markets are open and investors appear not too concerned about this.”

 

Mr Gallo has also become an authoritative commentator on ‘Additional Tier 1 Capital’ [including ‘contingent capital’]. Over the last few years, these forms of bank capital have  been made [by regulatory authorities] more central in judgements of bank capital adequacy ratios. Here is an opinion piece on CoCos for the Financial Times by Alberto Gallo.

 Ken Odeluga

 

 

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