On Friday, European bank regulators tried to reassure the markets that in a severe recession and collapse in European government bond markets, only seven of the 91 leading European banks they tested would face a shortfall in core tier 1 capital ratios below 6%, amounting in aggregate to just €3.5 billion.
If anyone actually feels reassured by this, Euromoney would appreciate a draw of whatever it is they are smoking.
In May 2009, when the US Federal Reserve announced the results of its stress test of the capacity of the 19 largest US banks to withstand losses resulting from a severe recessions lasting to the end of 2010, it required them to raise $75 billion in additional capital. The authorities laid down a challenge both to banks and their private shareholders: supply enough capital for the banks to keep lending, or be faced with the US government injecting it on punitive terms.
The US testing process had provoked plenty of cynicism among financial market participants. No policymaker would publicize any test result that might provoke panic and destabilize the banking system: surely this was a confidence trick. But the demand that new capital should be raised gave it a stamp of credibility.
Within minutes of the results being announced, banks were busy raising it. Less than two weeks later, Bank of America had raised $13.5 billion from equity sales and disposals. By the end of the month, investors had already supplied most of that $75 billion. Investors had gone very underweight US bank stocks earlier in 2009 and were now keen to buy back into the sector as bank earnings boomed and the Fed’s quantitative easing made the recession outlined in its own test seem an increasingly unlikely outcome.
Europe’s experience is likely to be different, and not just because of lingering doubts about the tests’ credibility, renewed worries about the economy or Europe’s constipated rights issue process for raising new equity.
Regulators and banks don’t want to spark a rush to the equity markets. They want the largely favourable test results by themselves to re-establish banks’ unfettered access to wholesale debt financing. European banks, many with much higher advances to deposits ratios than their US peers, desperately need this. They hope that the stress results will restore creditors’ confidence in them without banks having to issue dilutive new equity at a time when their shares are trading at a discount to book value.
But debt investors remain nervous about banks’ asset quality, leverage and capacity to maintain capital if earnings shrink in a slowing economy.
Of course, the regulators would have been foolish to set out an excessively stern test that might have increased market panic if many banks failed it. However, investors are not impressed by the tests’ haircuts applied only to sovereign debt held in banks’ trading books and by the failure to model any capital loss in the much larger exposures in their hold-to-maturity banking books from a sovereign rescheduling.
While peripheral European sovereigns successfully rolled over new auctions of debt in July and immediate concerns about sovereign default receded, the very doubt that prompted the European bank stress test in the first place is over the public sector’s capacity to finance itself and, by extension, to raise funds needed for further bank bailouts in the event of a dreaded double-dip recession following on from fiscal consolidation.
As analysts at Credit Suisse pointed out last month, the most significant and often missed point was that the stress test was not really a test of banks at all. Rather, it was a test of the ability and willingness of the official sector to recapitalize any banks that failed it. Coming up with €3.5 billion isn’t much of a test.
For the stress test to have any credibility, all participants reasoned, some banks would have to be found short of the capital required comfortably to withstand an EU GDP growth rate for the next two years rate three percentage points lower than official European Commission forecasts and a deterioration of conditions in the European sovereign bond market from early May 2010.
Seven banks in total, including five Spanish cajas, one German real estate lender and a Greek bank, were duly wheeled out as unable to maintain core tier 1 above 6% in the worst case envisaged by European bank regulators. Helpfully, most of the sacrificial seven had already been bailed out by their national governments. Less helpfully, analysts didn’t wait for the test results but instead came up with varying estimates for European banks’ new capital needs under such an economic downturn of anywhere between €60 billion and €120 billion.
Credit Suisse identifies €130 billion of official sector capacity available at reasonably short notice to recapitalize banks. The dedicated German SoFFIn fund has €50 billion of remaining capacity. The Spanish bank reconstruction fund Frob has legal authority to raise €100 billion, but had only pre-funded €12 billion of that last month. Greece agreed to a €10 billion fund for bank recapitalization as part of its IMF programme agreed in May. That totals €72 billion.
France, Italy and other EU governments without such official bank bailout funds have previously shown themselves willing to invest directly in banks and Credit Suisse estimates another €58 billion might be available. Then there is the EFSF itself, with a borrowing capacity of €440 billion. This is earmarked to provide emergency finance to European sovereigns. It’s not immediately clear whether or how this might be redirected to bank recapitalization.
Credit Suisse argues that in the weeks ahead it will be possible to deem the test a success only if it is seen to demonstrate that, despite appearances, the EU has a coherent policy on bank bailouts. If it does not, the consequences could yet be severe in terms of liquidity hoarding and a renewed breakdown in the bank funding market.
What of the private market investors who famously piled into US bank stocks in the aftermath of the Fed’s stress test results? Will they play any role in recapitalizing European banks in the second half of 2010?
As they lose revenues from cancelled IPOs, ECM bankers are desperate to make a case for banks to issue. Last month, they were breaking down European banks into three categories: clear passes, with no need for new capital; clear fails to be supported out of official resources, and those banks declared to have passed the test by regulators but over which investors still harbour doubts.
Who might provide new capital to these last? European banks might once again have to go knocking on the doors of Middle Eastern and Asian sovereign wealth funds. These will be a demanding audience. Look out for deals like the one Barclays struck with Middle Eastern investors in 2008, paying high coupons on instruments senior to equity, including mandatory convertibles. These and similar reserve capital instruments saved Barclays. Today bank regulators are less inclined to accept anything other than pure equity as core tier 1 capital.
But if that’s all the private markets will provide, then let’s see what the official sector in Europe is prepared to supply instead.
see also:
Stress test reaction: Investors like it, but analysts say it leaves more questions
July 28, 2010
FX comment: CEBS stress tests have no punchline
weeklyFiX July 23, 2010
FX research roundup: Euro positives even in the negatives
weeklyFiX July 23, 2010