Is it really over?

The ECB/EBA announcements of the results of their complex series of stress tests, comprehensive assessments and asset quality review (AQR) generated quite a lot of sound and light, but not much fury- apart from the Italians.

Apart from Monte dei Paschi, none of the “failures” were seemingly that significant in terms of scale and impact. However, dig a little deeper and a number of questions emerge, which make the Awbury team believe that there is more to ponder than may at first be apparent.

With one minor exception, all the German banks in the sample “passed” the various tests, albeit in some cases by a modest margin. Given the structure of the banking system; its experience and performance during the financial crisis; and the outlook for the German economy, we must admit that we find that “fact” a little surprising. Obviously, the counter-argument would be that they were all subject to the same tests as everyone else, but we cannot help having a lingering suspicion that all is not quite as it seems. Sadly, only the next financial crisis will demonstrate whether our suspicions are well-founded, or based on our cynicism about the true rigour of the process and the scope for “judgement” being exercised. For example, of the 16 banks that came closest to not meeting the minimum 5.5% CET1 ratio under the adverse stress test scenario, 7 were German.

While banks passed under the parameters set, those were at a point in time and lacked a number of relevant forward-looking inputs. As such, applying a “fully-loaded” Basel III capital requirement, which is being phased-in over the next few years, would have caused a number of additional “failures”.

Over four fifths of the banks surveyed were found to have under-provisioned in some way, whether by over-estimating values or having a feeble level of loan loss reserve coverage. The aggregate adjustment made was some EUR 136MM, a not insignificant sum. Given the inherently high-leverage within banks; the amount of wrong-way risk they often have; and the tendency for realizable values to plummet in a stress-scenario, we believe that, in the real world, the situation would be even worse than the outcome of the AQR. The banks’ annual results for 2014 may give more clarity on this point.

The analyses were not based on market valuations; and so we wonder whether in a future systemic crisis, when correlations tend to rise; the herd rushes for the exits; liquidity disappears; and the amount of “linkage” between banks becomes more apparent, the banks would really have the capital buffers the ECB/EBA tests would have us believe.

You may call us cynical and perhaps even self-serving, but no matter what every “test” published to date, whether in the EU or the US, has shown about the “soundness” of a banking system, every subsequent systemic crisis has evidenced that their results and comforting prognostications were, in fact, a sham. Banks as currently structured are still inherently unstable and overly complex institutions.

Frankly, we are much more comfortable with the risks posed by a diversified and unleveraged P&C (re)insurer; and we believe that our clients recognize that in terms of their own view of counterparty risk and the probability of the protection they have sought being “good” in all realistic scenarios.

-The Awbury Team

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