Wednesday, July 28, 2010

RGE on the European Bank Stress Tests

We've been digesting the results of European bank stress tests, which appear to have made neither markets nor analysts less stressed. According to the Committee of European Bank Supervisors (CEBS), only seven banks failed to pass muster out of the 91 tested. The CEBS also announced on July 23 that the recapitalization needs of the failures—five Spanish cajas, Germany's Hypo Real Estate (HRE) and Greece's ATEbank—amounted to €3.5 billion (US$4.5 billion).

Several aspects of the testing process make us skeptical about the results. We're still not convinced of the European banking sector's resilience and therefore are concerned about the scale of the potential liabilities that stressed sovereigns need to backstop amid a low-growth environment.

In a Strategy Flash available exclusively to clients, we address a crucial deficiency of the stress tests: the absence of a sovereign default scenario. Optimistic commentators point to the rebound in U.S. markets after the Supervisory Capital Assessment Program (SCAP), which faced significant criticism, as Europe's equivalent is now. But while the U.S. SCAP tests modeled the key concern of the market—future property risk—and forced banks to recapitalize, the European tests did neither. The former would have meant stress testing sovereign debt in a default scenario. The only valid argument for not doing so is that the ECB could monetize the debt, with the €440 billion European Financial Stabilization Facility (EFSF) serving as a fiscal fallback plan for sovereigns whose solvency concerns limit their bank backstopping capacity. But in the event of several sovereigns drawing on this fund—which we see as not entirely unlikely—the guarantees would be worthless.

We also take issue with the Tier 1 ratio of 6% the CEBS used, which we see as a poor benchmark that can hide hybrid instruments that have proven to lack loss absorption capacity on a going concern basis. What's more, while only seven of the 91 lenders failed to pass this bar, there were at least 10 other marginal fails, with Tier 1 ratios of 6.3% or less. Had the threshold been 7%, 24 banks would have failed the test, notes an RGE Critical Issue parsing the results.

The capital shortfall figure likewise warrants closer inspection: For Spain, it includes €14.4 billion of public funds committed and pre-approved before the stress tests. Effectively, the tests rely on ongoing government support (almost €200 billion in capital injections, amounting to 1.2% of the aggregate Tier 1 ratio) and sovereigns' guaranteed backup from the EFSF and ultimately the ECB. But utilizing the EFSF, which was originally intended for liquidity support, for bank recapitalizations could expose the sovereign to refinancing risks and rising spreads. "In situations of insolvency," Dr. Roubini asserts in a June 28 RGE Analysis, "official support not only fails to prevent the eventual default, but also exacerbates the trouble, causing more damage to the country and even to its creditors."


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Original content Bob DeMarco, All American Investor