With stress test results due in less than two-and-a-half weeks’ time, Europe’s investment banks have been busy churning out their own versions. One of the best we’ve seen landed in our inbox on Monday.

It’s from UBS, and specifically their banking analysts Alastair Ryan and John-Paul Crutchley.

Both of these guys have been pretty on the ball in recent months; covering Greek and Spanish banks, and the general over-reliance of eurozone banks on European Central Bank (ECB) funding.

So without further ado, here are the results of the UBS eurozone bank test, click to enlarge:

That’s right, everyone passes.

That may seem like something of a damp squib to you. But bear in mind Germany, Spain, Austria and France have already said that their most important banks have passed domestically-administered tests.

And UBS is running a relatively simple test — mostly based on credit loss estimates — and not taking into account many differences between eurozone countries. They do, however, assume some US stress test-style features like a 3 per cent haircut on all European government bonds.

The point of the exercise is to demonstrate just how useless these stress tests could turn out to be — in terms of satisfying market concerns of sovereign bond losses, loan risk, and ECB usage, anyway.

As UBS put it — rather mildly :

In this test, we applied exactly the same scenarios to every bank, regardless of individual circumstances. However, the broad spread of European economic environments suggests that this is likely to be a poor guide to actual capital at risk.

If the stress tests are useless, from the perspective of assuaging investors’ fears, what should markets be looking at? In UBS’ opinion it should be one thing — wholesale funding. But, as UBS also note, wholesale funding is, for many banks, now harder to come by and probably more expensive:

We believe that, in order to potentially offer a turning point in the narrative of this ongoing crisis, a European stress test should realistically seek to answer the question of how much wholesale funding bank balance sheets can support under today’s conditions. We note recent press reports (FT) that the authorities believe up to €30 billion in equity may need to be raised by the system as a result of the tests. This would equal 0.1% of the systems’ balance sheet, and seems a figure too modest to achieve the change in narrative.

We believe the answer is likely to be a potentially more challenging one: that in order to support high levels of wholesale funding, banks may need to demonstrate levels of core tier 1 well in excess of those that most Eurozone banks currently hold.

With that in mind, the structure of banks’ balance sheets becomes much more important.

And this is where, believe it or not, the Turkish example comes in:

We also see another outstanding and challenging issue. If sovereign volatility is going to be with us for some time, as elevated debt levels and deficits suggest, then banking systems may need to seek to reduce their wholesale funding dependence further. At an extreme, Table 6 shows the structure of the Turkish banking system’s balance sheet. It is strikingly straightforward – deposits and equity account for four fifths of the total balance sheet of the system . . .  in our view, the agenda in the Eurozone has changed, and sovereigns, the cumulative non-domestic funding requirements of the government and financial sector together, and so on, are more important than since the euro’s creation.

Somewhat more like Turkey

It may therefore be that banks should look somewhat more like the Turkish example, and somewhat less like their own recent history. In Chart 26, we look at the major European banks through this lens. With the average of (deposits + equity) to total assets at 46%, the distance to travel may well be a significant one.

To achieve such lofty deposit/equity to assets ratios, banks will either have to shrink liquid assets or raise more equity — assuming signficiant deposit growth isn’t possible right now.

The other choice is to do it now, or wait until later. Says UBS:

The advantage of doing it over time is that pre-impairment profits may amortise the issue away without the need for dilutive equity issuance, or government schemes (such as NAMA) to take assets off the banks. The disadvantage is that amortising the problem over time is likely to lead to a chronic lack of credit availability, constraining economic growth.

With Europe now almost three years into the financial crisis and no natural end in sight, we believe the option of getting things over and done with is becoming more and more preferable.

The future of banking — thy name is recapitalise? And err, Turkey?

Related links:
Europe’s ‘toothless’ bank tests making matters worse - The Telegraph
Post-ECB stress test (dis)order – FT Alphaville
The price (and cost) of bank funding in Europe – FT Alphaville

This entry was posted by Tracy Alloway on Tuesday, July 6th, 2010 at 8:15 and is filed under Capital markets. Tagged with bonds, ecb, Eurozone banks, Greek banks, spanish banks, stress tests, wholesale funding. Edit this entry.