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Spanish banking sector: Senseless stress

Stress testing the Spanish banks to an unrealistic core capital ratio was an exercise in futility.

Although the Wyman Berger stress tests were only ever designed as a communications exercise to quell market panic over the state of Spain’s banks, what they reveal should be seen as somewhat alarming. When the IMF and the Bank of Spain produced their top-down estimate they concluded that €37 billion of extra capital was needed to reach a 7% core tier 1 ratio.

The Bank of Spain set the parameters under which both consultants were operating – a base case and an adverse case. The base case assumed weak growth returning to Spain in 2014 with unemployment stabilizing at 23% and land prices falling 25% in 2012 and 12.5% in 2013. The adverse scenario entailed two consecutive years of severe economic recession with real GDP declines of 4.1% and 2.1% and unemployment rates at 25.1% and 26.8% in 2012 and 2013 respectively. Real estate prices fall 20% and land prices 50% for a total peak-to-trough fall by 2014 of 37% and 72% respectively.

Oliver Wyman points out that the severe stress scenario was more marked than similar exercises in most other jurisdictions, with the downturn persisting for three years rather than two and most critical variables being stressed at more than two times the historical standard deviation. The problem is that it doesn’t look that stressed from here. In fact, it looks like the more likely outcome.

But the main problem with the tests is the assumption that the sector will get away with a core capital ratio of 6%. Oliver Wyman calculated its worst-case €62 billion figure on the basis that the €270 billion in additional losses in the system would be mitigated by a €70 billion build-up of profit, €12 billion of credit deleveraging, and the banks being allowed to eat through €55 billion to €61 billion of existing core capital as the required ratio drops from its current 9.4% to 6%. If, however, the current capital ratio levels are maintained the shortfall will be more like €110 billion to €140 billion, not €62 billion.

This probably explains the collective shoulder shrug that the tests have received, with the market waiting for a comprehensive audit of individual Spanish banks that is now due in September.

Concern is moving from the much-discussed real estate losses to residential mortgage exposure, which accounts for 37% of loans in the system and is coming under extreme pressure as the economic situation in the country deteriorates. The likelihood of a banking sector facing the problems that Spain’s does – being able to fund and keep operating with a 6% core capital ratio – is slim. So it doesn’t make a lot of sense to stress for it.

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