We’re on European bank stress test methodology watch.
And according to Nomura’s European bank team, the key question is how much time banks will be granted to deal with or absorb projected losses. In other words, whether they’ll be able to fund stress test-exposed losses using their projected future earnings. Or not.
To illustrate the point, Nomura have done their own (basic) European bank stress test.
Their assumption: non-performing loan ratios triple from their current levels and the loss rate is 50 per cent. They’ve also assumed, topically, a 60 per cent haircut on Greek government debt.
The results look like this:
The black triangle is the estimated loss, the light pink is banks’ earnings buffer (or, one year of pre-loan loss provisioned profits) and the red is the capital buffer (core Tier 1 capital ratio over 4 per cent). What you want is a loss estimate that eats into the earnings and capital buffers as little as possible.
Here’s what the analysts say:
The chart demonstrates the importance of the time banks are allowed to absorb losses. On the assumption of three years, most large-cap European banks would not need to raise additional capital. However, on the assumption that losses are incurred immediately, most large-cap European banks would need to strengthen their capital bases to meet the 4% minimum.
And on a wider note:
Ultimately the credibility of the stress test will depend on the underlying assumptions and their transparency. Consequently, we hope regulators will publish these in detail. If the stress scenarios are not painful enough, do not acknowledge the default risk from some European countries or if the transparency of the assumptions used is poor, publishing the stress test could be counterproductive and raise more questions about solvency. In this context, it is important that there are clear plans to strengthen any large banks that fail the test, in a manner similar to the US/UK stress test . . .
Repeat after us; a stress test is only as good as the assumptions that underlie it . . .
Give us the figures on Europe’s toxic banks – Wolfgang Münchau, FT
Sovereigns not included? More on Europe’s stress tests – FT Alphaville
Must Europe’s stress tests fail in order to succeed? – FT Alphaville