Europe’s credibility under stress
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Europe’s credibility under stress

After omitting an outright sovereign default from its latest banking system stress test, the EBA must set a high capital ratio for banks to pass, or risk losing all credibility. As Euromoney went to press at the end of March, Portugal appeared to be on the brink of seeking assistance from the EU and IMF to roll over its finances, peripheral sovereign spreads were widening once more, and Ireland was due to present plans to recapitalize its banks that might require senior unguaranteed bondholders to share the burden. And the European Central Bank had managed to convince the markets that it would raise rates in April, as the consensus grows among credit analysts that default rates might have hit a cyclical low and be set to rise before too long.

So it’s a good time to be doing a banking system stress test, as long as it’s a credible one.

Financial markets in Europe have behaved with almost remarkable calm in the light of the continuing and interlinked stresses between sovereign debtors and banks. The contingent liabilities of thinly capitalized and precariously funded banks weigh on the sovereigns; the prospect of losses on holdings of government bonds weigh on the banks. Sovereign and bank fortunes are intertwined as Deutsche Bank analysts illustrate in their report Looking for credible stress tests by tracing the historical relationship between five-year credit default swap premia for the country’s six biggest banks and five-year Spanish sovereign spreads and yields to Bunds.

Before the financial system crisis that began in the summer of 2007 the correlation was negative. Since the bankruptcy of Lehman in October 2008 it has increased sharply, jumping noticeably in October 2009 when the Greek government warned of a 12.7% of GDP budget deficit.

In order to ease the stress on peripheral sovereigns, those countries’ banking systems must be able to fund themselves at market rates that allow for medium-term profitability. To do that, banks must be adequately capitalized to absorb further shocks. If tough but reasonable stress tests suggest they might not be, they must quickly present credible plans to raise capital.

It’s easy enough to envisage how a weak economic performance might increase default rates, reduce banks’ profitability and force them to recapitalize by selling assets, so leaving them vulnerable to falling asset values in a vicious cycle. What would a credible stress test need to cover in such dire circumstances?

It probably needs to include a sovereign default and debt restructuring with losses calculated across banks’ hold-to-maturity portfolios as well as their trading books. Markets are increasingly pricing in the likelihood of such an event. The EU summit at the end of March seemed to ratify the notion that assistance from the European Stability Mechanism after June 2013 will be based on a debt sustainability analysis that implies some form of net-present-value write-down. And that raises another concern of burgeoning liquidity and roll-over risk if investors start to shorten the maturity of funding they make available to sovereigns and banks.

Yet this is missing from the European Banking Authority stress test now being conducted for banks accounting for 65% of European banking system assets. How could the EBA compensate for what is almost universally considered to be a weakness in the test? Perhaps by setting the pass rate quite high, suggesting that banks that fail to maintain a 7% core tier 1 ratio under stressed conditions need to raise more capital. Deutsche Bank calculates that applying such a pass mark to last year’s discredited test would have raised the requirement on banks to raise additional capital from €3.5 billion to €55 billion.

That might appear very demanding. But establishing the resilience of a fragile banking system in a festering sovereign crisis can hardly be anything else.

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