A dose of stress for Europe27th October 2014

shutterstock_88963480What do the latest ECB European bank stress tests tell us about the health of our nearby continentals and their economy? They’ve taken a year to work on, and have just been published as 170 pages of the grandly titled “Aggregate Report on the Comprehensive Assessment”, so lets hope the stress of waiting was worth it.


Well, the headlines sound OK, with the EU’s banks showing a total capital deficit of just €9.5 billion to meet the latest stress tests. Before the crisis “just” had a rather different meaning, but these days when Central bankers have shown that they can sustain the unsustainable for many a year, €9.5 billion is a relative drop in the ocean. Remember these tests do not include British banks.


European banking stress tests have been much derided in the past, as banks who had recently passed fell under the wheel of the crisis within a matter of months. But now, of the 130 tested, just 13 are being told to raise capital to strengthen their balance sheets. €9.5 billion amongst 13 sound modest, especially when set against the net €40.5 billion raised amongst the 130 banks so far this year. So maybe this will make risky leverage a thing of the past? Sadly, no.


Over 6,000 clever people tested provisions for bad debts on 119,000 borrowers against the 170,000 pieces of security supporting them, and efforts to achieve a common standard in analyzing vulnerable loans, mostly amongst corporates and retail property lending.


Top of the class is Deutsche Bank (Malta), with an apparent “Common Equity Tier 1 capital ratio adverse scenario” of 138%. That sounds strong. Bottom of the pile is Eurobank of Greece, with potential negative capital of 6.4%. Four of the 13 sat in the naughty corner are Italian.


The adverse scenario anticipates rising interest rates, a fall-off in GDP of 6.6% below the expected level by 2016, and many other nasties, leading to aggregate loan losses of 4.5%. That doesn’t sound like much, but that 4.5% totals €378 billion. So, if these tests are adrift by say 0.1% that’s an extra €8 billion, or 1.0% out and that’s €84 billion!


As we have seen recently with Tesco, we are finding that approaches to accounting are not black and white, but can involve considerable areas of grey. Assessments that once seemed rational to sensible people relying upon a continuation of the norm can get caught out by rapid change.


So what are these “safety” %ages calculated against? Risk-weighted assets is the answer, with the regulators applying risk weighting, so that a loan to a state is seen as lower risk than a loan to a small business. That’s great if you assume that states will always repay their debts, but if not it causes all sorts of panic such as we saw recently in the potential Scottish denunciation of their “share” of the British debt.


So what did the tests not allow for? Deflation. As we know, years of steady inflation can help to reduce the real burden of debt, and/or raise the value of security set against those debts, which is a real boost to a stress test. These stress tests allow for cumulative inflation of 1.9% across 2014 to 2016. Yet 10 of the 28 European countries are currently experiencing flat or falling prices, so this is already looking questionable, with the report almost squirming on the point without admitting that it may have been overtaken by events.


In testing a bank’s assets (i.e. what they have lent out) we also need to consider how they apply their surplus funds. It’s great having surplus cash, often placed with other banks, central banks or short-term government bonds, but what if it is in the wrong place when catastrophe strikes and the music stops? Happily 12 of the 130 are deemed to have no or minimal banking risk, and remarkably 3 appear to have been excluded from this test all together despite high intra-group exposure which has not been tested.


So what happens if we re-run the stress tests assuming flat or falling prices and collateral values, tweak the risk-weighting, allow for intra-group exposure and a higher default rate? Whilst we all hope that is beyond the realms of possibility, it is not beyond the realms of probability. As we have seen, the challenge posed by 0.1%, 1.0% or even wider variations is extreme.


The European Central Bank must be hoping for the best, as what this test does is to once again demonstrate the vulnerability of our monetary and banking systems. Sometimes sticking plaster isn’t enough.


The full report is available here: