Stress test Friday is upon us.
At 5pm London time/6pm Central European time, the Committee of European Banking Supervisors is scheduled to publish an aggregate summary of the results of the European bank tests. From then on, individual results will be published on an ad hoc basis by the banks or their national regulators.
At around 5.30pm the CEBS plans to publish all the individual results on its website.
FT Alphaville will be holding an extra-special stressed-out session of Markets Live from just before 5pm London time (12 noon NYC) onwards, which will see the fabulous and predictively-gifted Paul Murphy handle market and analyst reaction to results. He’ll be joined by whichever unfortunate London-based FT AV reporter chooses to stay past 5pm on a Friday to cover the results.
In the meantime though — here’s a handy Q&A courtesy of Goldman’s Nick Kojucharov.
To, you know, remind us all of what it is exactly that we’re waiting for.
On this eve of the eagerly-awaited European bank stress tests, details about the underlying assumptions and scenarios used are still hard to come by, which is somewhat ironic given that that a core aim of the exercise was to bring clarity to the cloud of uncertainty that currently prevails, and to promote transparency in the banking system. To bring our readers up to speed on the little information that is available, we have compiled a brief Q&A guide to what we think are the key issues.
1. Why are banks being stress tested?
Over the past few months, European banks have seen sharp rises in their funding costs and a significant sell of their equity. Uncertainty about the capital positions of these banks has certainly been a driver of this negative market reaction, but, as we discussed in detail in last week’s European Weekly Analyst 10/26, the close correlation between bank CDS and sovereign CDS in recent months (Chart 1) suggests that concerns about the sovereign debt situation have also contributed significantly. The relative scarcity of information about all these risks and exposures has engendered a lack of trust within the system, and polluted investors ability to distinguish the good banks from the bad ones. The stress tests are an active effort by the authorities to address this prevailing uncertainty and distrust, and are partly guided by the belief that analogous tests in the US a year ago were a catalyst for the improvement in public sentiment. Although officially the aim is to “assess bank’s ability to absorb further credit and market shocks” and to gauge “their dependence on public support measures,” we think the real power of the tests is the increased clarity and transparency that they will bring.
2. Who is conducting the tests?
The Committee of European Banking Supervisors (CEBS) and the national banking authorities are taking the lead in coordinating the design and implementation of the test, in cooperation with the ECB. In line with its mandate, the CEBS regularly monitors and tests the vulnerabilities of the banking sector, but this is the first time the results of these analyses will be released to the public on such a wide scale.
3. How many banks are involved and in which countries?
The test will cover 91 banks in 20 countries, which collectively account for 65% of total assets in the EU banking system. This sample is noteworthy in that it is designed to cover at least 50% of each national banking sector, and to incorporate a significant share of public banks (most notably the German Landesbanks and Spanish Cajas) for which we have the least financial clarity.
4. When will the results be released?
The CEBS will publish the results tomorrow on both an aggregated and bank-by-bank basis starting at 18:00 CEST. A press conference will follow an hour later.
5. What are the “stresses” applied and are they harsh enough?
The resilience of banks will be tested under two macroeconomic scenarios –baseline and adverse – each of which assumes a predetermined path for key economic and financial variables. The CEBS has not revealed the full range of variables, but GDP, unemployment, inflation, and interest rates are the ones explicitly mentioned (presumably house prices will also play an integral role). Details about the magnitudes of the various parameters and their differences between the two scenarios are also sparse, but we do know two tidbits:
- * The baseline GDP path for each country will be the European Commission’s latest economic forecast for 2010 and 2011 (Table 1). The adverse scenario will then assume a -3% growth deviation from this baseline for the EU as a whole, but we don’t know how this 3% shock will be distributed among the member states.
- * To simulate an increase in sovereign risk, the test will (if we understand it correctly) mark down sovereign securities to prices observed at the trough of the selloff in May of this year.
We think the GDP shock used in the adverse scenario is sufficiently negative to generate significant hits to banks’ loan books and other portfolio holdings, and is actually even more severe than the assumption used for the US bank stress tests in 2009.
The shock to sovereign securities is somewhat limited in the sense that it stress tests only for trading (i.e. mark-tomarket) hits and not for losses to securities which banks may have in their hold-to-maturity portfolios. But given that the focus of the exercise is on regulatory capital, and gains and losses on the hold-to-maturity books are generally not counted as part of this capital, the design of the shock is reasonable.
6. Are losses to banks sovereign securities the only market shock considered?
No, but it is the only shock for which we have any logistical details, even though it is probably the least important. Indeed, sovereign securities account for only about 5% of total assets on Euro-zone bank balance sheets, while the bulk are in the form of loans (57%), corporate securities (13%), and other assets (25%). In this sense, although sovereign debt exposure will be an important determinant of banks’ vulnerability to adverse shocks, we think their ability to pass the stress tests will primarily be a function of their resilience to credit hits on their loan portfolios. For a 3% drop in GDP growth, our best estimate is that resulting credit losses would amount to 1.5% of loans on aggregate EU balance sheets, or 0.7% of total assets (see European Weekly Analyst 10/26).
7. What benchmarks will be used to determine who “passes”?
Banks generally carry protection against credit and trading losses in the form of credit and capital buffers. The former refers to the retained earnings and reserves that banks have over and above what they have already provisioned for expected losses, while the latter is defined as the stock of capital that banks hold in excess of the minimum legal requirement. As far as we know, the CEBS and other parties conducting the stress test have not set a credit buffer threshold under which banks will be deemed to be “at risk.” The main test criterion therefore appears to be a capital buffer, and according to the FT and other sources, the minimum tier 1 capital ratio used to assess this buffer will be 6%. Banks that fall short of this ratio will have raise additional capital, although there is no deadline specified at this point.
8. Isn’t this benchmark capital ratio too low?
It is difficult to determine an “appropriate” threshold ratio – i.e. one that does not overstate the buffer of banks who are actually undercapitalized, but is at the same not too strict so as to force too many banks to go through the costly process raising new capital. That said, in the context of the European banking system, we do feel a 6% threshold ratio is a bit on the low end, and our bank analysts estimate that, at this ratio, very few banks will fail the stress test, and will, on average, be able to sustain a cumulative loss 10.2% on their loans (4.7% of total assets).
9. How should the results be interpreted?
If a bank passes, does it mean it is solvent? Not necessarily. Since the passing rate of banks will be a function of performance criteria and assumptions used in the exercise, banks which are deemed financially sound under these parameters may obviously fail under alternative specifications.
10. So does that mean that even “successful” results will not restore some order in financial markets?
There is obviously the risk that if too many banks pass and do so with a comfortable margin, the test may be judged as too easy to have actually been informative about the strength of the banking system, and markets may not draw any new comfort or optimism from the exercise. But if the test assessment criteria turn out to be objectively strict and the simulated shocks sufficiently “stressful”, then there may certainly be due cause for believing that the banking system is in better shape than most analysts believe. In any case, we think the main value of these stress tests in the first place is not the ultimate pass/fail marks assigned by the CEBS, but rather the clarity gained from having detailed and consistent information (capital positions, loss estimates) about the banks under consideration (especially the less transparent public banks). Such information should allow investors and market participants to better distinguish between banks, and, at the minimum, identify those which are at the extremes of the risk spectrum. This ability to separate the clearly good from the clearly bad will be important in mitigating problems of adverse selection, and thus keep risk premia and funding costs rise for the system as a whole from rising.
11. Do we have any indication of the results so far?
Although they will not be officially confirmed until tomorrow, recent comments by various European officials and press agencies suggest that the overwhelming majority of tested banks passed, and that the required capital raising will be limited. Spanish Minister of Finance Salgado, for example, announced on Tuesday that of the 8 private banks and 18 cajas tested, none failed, and that the Spanish banking will therefore not require additional capital.” This statement did not seem to jive with various outside estimates that anticipated capital raising in the range of €10-50bn (the IMF assumed €22bn in its worst-case scenario), but the Spanish newspaper El Economista reported today that the discrepancy seems to come from the fact that the Bank of Spain has allowed banks to count funding from its FROB facility as tier 1 capital.4 In any case, the balance of news is still consistent with better-than-expected stress test results, and so far we have only heard of two banks as being reported to have failed – the German bank HRE, and the Slovenian bank NLB.
Bring it on!
(Extra long) Related links:
The incredible restructured stress test - FT Alphaville
Stress-test rumours and reality – FT Alphaville
Some stressful reading for the CEBS – FT Alphaville
From stress test inferno to capital purgatorio – FT Alphaville
Shorting (and scheduling) the stress tests – FT Alphaville
The refined European bank haircut - FT Alphaville
CEBS reveals stress test details (at last) – FT Alphaville