So, how was it for you…?

Late on Friday evening, the EBA published the much-anticipated results of its latest stress test on the 51 largest EU-based banks.

As anticipated, the world’s oldest surviving bank, Monte dei Paschi di Siena (MPS), drew the “short straw”, with a stressed outcome that rendered it insolvent. As we predicted in our last post, there was a last-minute scramble by the Italian government to put together a bail-out that would minimize the risk of falling foul of the EU’s State Aid rules, or of the bank having to be “resolved”. So, a JP Morgan-led consortium is to provide an EUR 5BN re-capitalization and a mechanism intended to address MPS’s overwhelming non-performing loan (NPL) burden.

The MPS result, while very much “in the tail”, was only one of a number of interesting components of the stress test which, apart from the EBA, involved an acronym-fest of other institutions. It was meant to apply a common set of criteria and a consistent methodology to the chosen sample of 51 banks from 15 jurisdictions across the EU and EEA, with a view to assessing the impact of a number of so-called “risk drivers”, such as credit and market risk; but also, this time round (as part of operational risk) “conduct risk”. The minimum size criterion was EUR 30BN equivalent in consolidated assets. However, just in case smaller institutions thought they might escape unnoticed, the EBA is also going to conduct what it calls a Transparency Exercise this December of a wider sample of 100 banks.

One point to note is that there was no “pass” or “fail” outcome. The EBA took the view, not unreasonably, that with the EU banking sector’s average CET1 ration now above 13%, it was more important to assess banks’ forward capital planning (cf. the US Fed’s CCAR approach.)

Not surprisingly the “Brexit” scenario received an honourable mention; but the EBA took the view that its 3-year macro-economic stress scenario was sufficiently onerous in terms of the assumed shock to GDP that there was no need to adjust for “Brexit”.

While the average impact of the scenario was a (380bp) fall in CET1 from 13.2% to 9.4%, 14 institutions showed a swing of more than (500bps), including MPS with a swing of (1400bps)- a true outlier. Almost all that impact was driven by credit losses.

In terms of banks which were deemed to have the weakest “fully-loaded” CET1 ratios in the Adverse 2018 scenario (and ignoring MPS), there were 4 banks with a ratio below 7%, Raiffeisen (6.12%); BP Espanol (6.62%); AIB (4.31%); and Bank of Ireland (6.15%). The outcome for the 2 Irish banks does, of course, raise potential questions about their robustness, particularly in the context of the impact of “Brexit” on the Irish economy.

The stress test also calculated leverage ratios in the Adverse 2018 scenario; with 5 banks (excluding MPS), falling below the minimum 3% ratio: BayernLB (2.80); Deutsche Bank (2.96%); NordLB (2.99%); ABN AMRO (2.94%); and BNG (2.08%). While the leverage ratio still tends to receive less attention than capital ratios, it is important as a statement of unweighted capital strength.

While it might be argued that the overall outcome is a reason for having confidence that the European banking system is now much more robust than it was before and during the Great Financial Crisis (and in terms of available capital that is true), the process is, of course, stylized. It may have highlighted a few outliers and potentially more vulnerable institutions (with MPS in a class of its own); but its scenarios were not institution or country specific. Therefore, in Awbury’s opinion, while a useful exercise in terms of providing a consistent “ranking”, it is unlikely to identify the institutions most likely to fail in the real world, because events have a tendency to unfold in ways that stylized models do not predict.

The Awbury Team

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