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The ECB stress tests: hopes and delusions

October 28, 2014

Published in ‘New Europe’ Print and Digital Editions

Stress testsThe three main objectives of the Eurozone banks’ ‘Comprehensive Assessment’ as defined by the European Central Bank (ECB) and the European Banking Authority (EBA) are: to strengthen banks’ balance sheets; to enhance transparency by improving the quality of information available; and, to build confidence by assuring all stakeholders that banks will be soundly capitalized. The assessment was applied on 130 financial institutions, with total assets of €21 trillion, roughly 80 percent of the assets in the Single Supervisory Mechanism. Although it seems rather difficult to evaluate ECB’s 178-page report on the Assessment in just a few hours after its publication, some useful conclusions may still be drawn.

The comprehensive assessment consists of two components: the ‘asset quality review’ and the ‘stress tests.’ The former, although less spectacular than the tests, is a good indicator of the degree of divergence of views on non-performing loans between national authorities and the single European supervisor. The latter are meant to provide an evaluation of the banks’ solvency resilience to two hypothetical scenarios—under the baseline scenario, banks would be required to maintain a minimum Tier 1 capital adequacy ratio of 8 percent; under the so called ‘adverse scenario’ of a two-year recession, rising unemployment and declining house prices, banks would maintain a common equity Tier 1 ratio of more than 5.5 percent.

Regarding the asset quality review, some interesting results came out: first, non-performing exposure (that is: loans and mortgages in arrears) were increased by €136 billion to reach a total non-performing exposures of €879 billion; these €136 billion were loans previously classified as normally performing by national supervision authorities. The biggest amounts of re-classified loans were found in Italy (€12 billion), Greece (€7.6 billion), Germany (€6.7 billion) and France (€5.6 billion). If we relate these amounts to each country’s GDP, then Greece seems to be the European champion of miscalculation of lending risk, remotely followed by Italy. This is one of the Assessment’s most eloquent results.

Stress tests revealed that most problematic banks are in Cyprus, Greece and Italy. As far as individual banks are concerned, under the adverse scenario the Tier 1 capital ratio stands at -8 percent for Cooperative Central Bank of Cyprus, -6.4 percent for Eurobank of Greece, -0.4 percent for National Bank of Greece, and -0.1 percent for Monte de Paschi di Siena of Italy—to name a few of the most striking examples.

Overall, the tests led to a total capital shortfall of €24.6 billion across 25 participating banks, with Italy and Greece at levels well above the European average (9.7 billion and 8.7 billion respectfully). Other European countries do not seem to present excessive vulnerability, in regard to the criteria applied. In fact, the stress tests under the adverse scenario were applied to banks’ balance sheets as of the end of 2013; if we take into account capital raised within 2014, then the number of problematic institutions falls to ‘only’ 13. In other words, the ECB found that banks’ capital holes had since chiefly been plugged, leaving only a modest €10 billion to be raised; even the Greek banks will easily raise the sums required, probably from the Financial Stability Fund.

That was the bright side of the story; let’s look at these matters from a different angle now. First of all, there is a widespread feeling among bank analysts that ECB’s assessments are way too political. Both the ECB and the EBA were extremely careful not to offend or bother strong governments and national regulators. Thus, the qualitative re-assessment of assets brought insignificant adjustments, while non-performing loans were increased by a mere 18 percenteither the ECB deliberately underestimated such loans, or its assessment was a waste of time and the banks were clearly honest in their own assessments.

More to that, the Comprehensive Assessment is only a test of solvency carried out at a certain moment in time, but that doesn’t say anything about the banks’ ongoing viability their ability to generate sufficient returns to cover all their costs and yield profits. Also, the methodology used, that of risk-weighted asset ratios, is a poor guide to a bank’s strength and is highly contested by financial analysts. Finally, not all assets were covered by the study; actually less than half of the banks’ total assets were included in the calculation, excluding, for instance, those of the German savings banks, which seemed ‘too political’ to be assessed.

But above all, there is a widespread market feeling that these calculations do not change anything for the real business environment; nor will they contribute to reverse the credit crunch experienced by many European economies. Especially in the austerity-stricken European south, where loans to small and medium-sized enterprises remain very rare and extremely expensive, (7 percent spreads between deposit and lending rates are not unusual), there is little hope that the Comprehensive Assessment will contribute anything to growth.


From → Views & Opinions

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