Capital Markets, IFR, Germany - Fri October 25, 2013

Testing times

The third set of stress tests in three years is set to be published in early 2014. How do they need to be conducted to resolve outstanding concerns? What is the likelihood of this being achieved? If the tests are worth their salt, there will be banks across Europe will sizeable holes to fill – how will they do it?

If the European Central Bank needs guidance on how not to run a pan-continental banking stress test, it doesn’t need to look too far back. In the post-Lehman world, Europe has done two mass trials of its troubled lenders: both designed to identify weaknesses, both widely seen as embarrassing flops.

The first such test in 2010, supervised by the European Banking Authority, saw three Dublin-based lenders pass easily, shortly before one was forcibly nationalised.

A year later, Franco-Belgian lender Dexia passed the second test with flying colours. Its forecast consolidated Tier 1 capital ratio of 10.4% put it 12th out of the 91 European banks tested, but only months later came the first of three bailouts and the beginning of the group’s long, painful breakup.

So what can we expect from round three? One issue on which everyone agrees is that the ECB, preparing from late 2014 to become the region’s dominant banking regulator, the first in a series of steps intended to create a single banking union, will be a far tougher taskmaster than its predecessor. The EBA struggled to assert its authority over national financial regulators, lacked control over how stress tests were designed and filtered, and was hamstrung in its ability to rebuke failing banks.

Indeed, the driving force behind both the third round of stress tests, set to take place through the first half of 2014, and a connected asset quality review, was the European Central Bank itself. “The stress tests were a prerequisite of the ECB becoming the new banking regulator,” said Simon Samuels, banking analyst at Barclays.

For many if not most, the ECB’s aggressive approach makes sense. “They wanted to see what sort of garbage loans exist out there in Europe, and to draw a line under previous stress tests,” said one London-based banker. “They’re determined to ensure that this time [the stress test] is done right.”

Hopes are high. Many see the central bank as the only regulator capable of restoring credibility to Europe’s financial sector, while boosting bank valuations to levels last seen pre-crisis.

“They wanted to see what sort of garbage loans exist out there in Europe, and to draw a line under previous stress tests”

“I’m optimistic that the ECB will conduct a more searching and incisive form of stress test,” said Emil Petrov, head of capital solutions at Nomura. The new regulator will also count for support on US consultancy Oliver Wyman, hired in September to co-manage a thorough audit of the eurozone’s 130 largest lenders.

A few concerns linger. The ECB lacks a regulatory track record. It has still to provide much forward guidance on how the tests will be implemented, who will carry them out, and how, or indeed whether, struggling or failing banks will be censured. Those points will become clearer in the months ahead, but for now, said Barclays’ Samuels, “pretty much everything is unknown”.

What we do know is that the asset quality review and the third stress test are indivisible, with the former a necessary precursor to the latter. The AQR, said Simon McGeary, head of new products, EMEA, at Citigroup, is designed to show “that banks are correctly reporting risk weights and loan impairment levels. It ensures that the ECB is dealing with a reasonably consistent set of data”. Most experts believe the review will largely focus on four core areas of banks’ lending exposure: real estate, shipping, SME lending, and pre-crisis legacy assets.

At this point, it is perhaps useful to clarify the real nature of these two, new consecutive tests, other than to create a definitive starting point for a new regulator, and to start drawing a line under the European banking crisis.

The AQR, officially viewed as an exercise in judging how banks classify loans in general and non-performing loans in particular is also, said one London banker, “an effective way of measuring the size of the lie”. It helps the ECB assess every asset and liability within every eurozone bank through the same filter, creating a standardised value for everything from Tier 1 capital to soured property loans.

Fine-tuning the balance

Meanwhile the new round of stress tests are designed to measure the relative strength of banks at times of future crises: how much, if any, capital lenders would need to raise if, say, interest rates spiked or growth slumped.

For ECB officials, the key challenge in the year ahead will be to ensure that the tests are taken seriously by the wider investing world. If the third stress test is discredited, the ECB stands to look soft-clawed at best and powerless at worst. If it cracks down too hard, revealing previously unseen legacy issues, it could shatter all lingering confidence in the industry.

It is a fine line to tread, as the US found in 2009, when it asked, and in some cases forced, its troubled and recalcitrant lenders to boost capital ratios. Some banks, said Nomura’s Petrov, will “need to be seen to fail, or the process won’t seem credible”. Citigroup’s McGeary said: “If everyone passes with flying colours, or even just scrapes through, markets will wonder whether the ECB really had a proper look under the bonnet.”

Some lenders, no doubt spurred on by national regulators keen to avoid public humiliation in next year’s tests, are now seeking to get ahead of the game by raising fresh capital on their own terms. Spain’s Banco Sabadell has raised raised €1.38bn (US$1.9bn) from a share sale earlier this month, while Austria’s Raiffeisen has long mulled a new rights issue.

Some lenders, like Italy’s Monte dei Paschi di Siena, have little choice if they want to cover loan losses and other charges. “You can expect to see more international regulators ensuring their banks are in a position where they can’t fail next year,” said Samir Dhanani, a member of Credit Suisse’s credit structuring team.

Curiously, that is also taking place in countries that sit outside the eurozone. “The UK, Denmark and Switzerland have forged ahead with early compliance measures, which should head off some of the issues set to come up next year,” said Sandeep Agarwal, head of DCM EMEA at Credit Suisse. The Bank of England’s ongoing stress tests, “modelled on the US experience and likely to be vigorous”, said Gordon Taylor, head of financial institutions DCM at RBS, may provide helpful guidance to ECB officials.

This also creates potential trouble on both sides of the fence. Banks and national regulators, keen to be dashing and decisive rather than reacting passively to next year’s test results, “may end up in a race to the top, as they seek to ensure that banks within their own jurisdictions comply with the most stringent regulations,” said Nomura’s Petrov.

If eurozone lenders opt to raise provisioning levels across the board, whether by selling fresh equity or by issuing continent convertibles to boost Tier 1 debt, ECB officials could struggle to remain relevant. But if eurozone lenders pre-empt the stress test by raising provisioning and/or capital in advance, it may affect Europe’s central bank, if only from a public relations perspective.

“If we see a new surge in capital raising now, then next year’s tests could conclude that things are pretty much fine,” said Barclays’ Samuels. “This may deny the ECB the prized headline of being seen as bold and decisive.”

Plenty of unanswered questions exist. Will existing national banking regulators become mere glorified rep offices subservient to the ECB? And which countries have the tattiest banking sectors? We won’t know until next year’s tests are released, but most analysts and bankers see Spanish banks surprising on the upside, with French and Italian banks and regional German lenders faring poorly.

Some see Europe being split into “northern-specific” (crisis management and loss-absorbing capacity) and “southern-specific” (asset quality and common equity raising) problems. Chris Tuffey, head of debt syndicate at Credit Suisse expects next year’s stress tests to be “less about north versus south Europe and more about good versus bad”.

While European officials are naturally keen to sever the poisonous link between banks and sovereign debt – a process seen as essential to the creation of a Single Supervisory Mechanism – it is not clear how this can happen in the short term. Eurozone banks have spent the past few years snapping up virtually all sovereign debt going.

According to national data, the amount of Spanish government debt held by Spain-based lenders as a share of all bank assets rose to 9.3% by end-June 2013, from 5.4% two years ago. In Italy the shares jumped over the same period to 10.3% from 6.5%. This fact alone, said Carlo Mareels, a credit strategist at RBC Capital Markets, “may make it harder to break the negative feedback loop between sovereigns and banks”.

A further key point remains: what punitive measures will the ECB impose on any bank unable to pass next year’s stress tests? “For me the key question is what powers and teeth will the ECB really have to intervene,” said RBS’s Taylor. Barclays’ Samuels said: “If banks fail stress tests and are told they have to raise capital ‘or else’, they may reply, ‘or else what’? Plus, the ECB could easily scold a bank, but the bank is only going to issue the new regulator with a torrent of stats telling them why they are wrong.”

Much of this remains idle if interesting speculation. For the ECB, this is the calm before the storm. Next year, the real work starts, when a new banking regulator will canter into town, determined to do a better job than its predecessor. That won’t prove a difficult job. But everything else will.

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