European banks could face €400 billion capital shortfall in EBA/ECB stress tests

Louise Bowman
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Signs of a U-turn in thinking at the top could see bank balance sheets finally cleaned up in ‘Europe’s Takenaka moment’, according to analysts at Berenberg Bank, warning a more punitive leverage ratio could take markets by surprise.

Nick Anderson, banks analyst at Berenberg Bank in London, believes that things could be about to change for Europe’s beleaguered banking system.

“In the last couple of months, there has been a U-turn in thinking,” he claims. “Everyone is beginning to realize that the problem in Europe is the balance sheets of the banks. Until these are cleared up, we won’t get lending and we won’t get economic growth.”

For this reason, he reckons the jointly run ECB review and EBA stress-testing of 140 European banks next year could finally have real teeth.

“We can’t stress enough how important the EBA/ECB audit is,” he says. “This has the potential to be Europe’s Takenaka moment,” he claims, referring to Japanese finance minister Heizo Takenaka’s tough plan to tackle bad debts at Japan’s banks introduced in 2003.

“The market is not forecasting the capital shortfall that this will throw up,” he warns, calculating this could be as high as €400 billion.

Describing bank capital as misunderstood, misused and misplaced, Anderson and colleague James Chappell argue that the equity-to-assets ratio is a far better metric by which to judge a bank’s risk of failure than a bank’s capital ratio under Basel III. Together with the leverage ratio, this should be the prime metric by which a bank’s health is measured.

Anderson claims the equity to assets ratio has a far better track record of predicting losses than Basel III capital ratios have. “The original thinking behind Basel was noble but the Basel system has been so heavily gamed by the banks that it is no longer viable,” he says. “It is causing all sorts of behaviour whereby banks are optimizing for regulation, not for risk.”

Anderson and Chappell have therefore devised two equity-to-asset calculations to determine the health of a bank. They reject suggestions this approach is too simplistic, saying that: “We would rather be roughly right than precisely wrong.” They point to the case of Dexia, which had a capital ratio of 12% when it failed, but an equity-to-assets ratio of just 1%.

Their thinking entails two calculations: a plain ratio and a pain ratio. The former calculates the risk of the institution failing today, or the idiosyncratic risk, and the latter the risk in a systemic event. Or in their words: plain is what you see versus pain, which is what you get.

“Basel III confuses what capital is for,” says Anderson. “It looks at expected loss where what capital is for is unexpected loss – Donald Rumsfeld’s unknown unknowns. Equity-to-assets has simplicity and accountability; has a good record of predicting bank failure.”

He adds that Basel capital adequacy calculations have become far too complex, pointing to executive director of financial stability at the Bank of England Andy Haldane’s contention that under Basel I it took 10 calculations to work out a bank’s capital ratio while under Basel III it takes more than 200 million calculations.

Anderson and Chappell argue that the demands of the Basel regulations have forced banks to resort to RWA optimization – or, as they say, “the two most dangerous words in finance”.

They point to Nordea, which recently sold its banking, insurance and leasing operations in Poland to state-owned PKO Bank Polski for $880 million, as a recent example of this.

They claim that while the deal will make little difference to Nordea’s income statement, it releases 50 basis points of capital and that is its motivation. Nordea chief executive Christian Clausen has said, however, that the sale is the result of the bank focusing on markets where it can achieve competitive scale.

Nevertheless, Anderson and Chappell state: “The regulatory tail is wagging the bank dog. Banks focusing on Basel do not manage their risk properly.”

Haldane has said an equity-to-assets ratio of 7% or more is needed to guard against bank failure and Anderson concurs that “between 6% and 8% feels like the right number”.

The volume of level-three assets on some European bank balance sheets – illiquid assets that are in industry parlance ‘marked to myth’ – is of particular concern given their sensitivity to any change in valuation.

A haircut on the level at which these assets are held on the balance sheet can have a meaningful impact on the equity-to-asset ratio of those banks that have a high percentage of level-three assets to tangible equity.

Particularly susceptible are Credit Suisse and Deutsche Bank. Credit Suisse has 133% level-three assets to tangible equity, which Anderson and Chappell calculate would translate to a 38bp hit to their equity-to-assets ratio in the event of a 10% haircut. Deutsche Bank has 96% level-three assets to tangible equity and would face a 29bp hit.