A week earlier, we presented Moody's proposed take on which banks are at risk of failing Europe's Stress Test version 2 (which is nothing but another huge waste of time), the results of which are due to be announced later today. The event will likely be market moving although we expect it will be at most 3 months before a bank that passed the test fails in spectacular fashion, laying the groundwork for next year's Stress Test part 3: the most stringent of all, and so forth. Below is RanSquawk's comprehensive take on what to expect from today's announcement.
- Increased transparency requirements for banks may leave the most exposed to weak sovereigns vulnerable.
- Major banks expected to pass comfortably.
- Results expected after market around 1700BST.
Stressing the Eurozone…round 2
Last years stress test results indicated that despite a modest capital shortfall of EUR 3.5bln, overall, the EU banking system was well capitalised and that there was no major risk stemming from sovereign exposure. However, policy makers suffered a massive credibility blow after Ireland was forced to seek monetary assistance after Irish banks lost access to capital markets following revelations of massive financing gaps which in turn endangered the country itself. As such, this year’s stress tests, which have been carried out on 90 banks, have been designed to be more stringent in nature and should provide market participants with some degree of relief.
- The test is being carried out on 90 banks to assess the resilience of European banks to a hypothetical adverse scenario on a static balance sheet (as of December 2010), over a two-year time horizon.
- The European Banking Authority (EBA) requires banks’ core tier 1 capital to remain above 5% after at least one of the worst-case scenarios, which include a drop in GDP over two years of 4%.
- The tests will assess the ability to handle a 0.5% economic contraction in the Eurozone this year, as well as a 15% drop in European equity markets, together with possible trading losses on sovereign debt.
- Banks must also list their exposures to commercial real estate, residential property, corporate lending and sovereign debt by country. However the tests won’t include a sovereign default.
- Finally, banks will be given 6 months to announce recapitalization measures.
- Latest reports indicate that results will be published at around 1700BST.
A chain is only as strong as the weakest link...?
Originally 91 banks were to be tested but yesterday German bank Helaba became the first casualty by ruling itself out of the test because it was unable to comply with the EBA’s capital standards. This year’s stress test does not allow the inclusion by banks of strategic changes made after 31st December 2010 other than pure capital raising or mandatory restructuring, something Helaba could not pass without. The increased scrutiny in this year’s stress test has created some unease amongst the banks because of the unprecedented disclosure of loan portfolios, sovereign debt holdings and sovereign-related derivative positions. Banks are worried that rather than calm the markets, the test results could single-out those banks which are most at risk with targeted speculation. To mitigate any fallout Eurozone ministers are already working on backstop measures to protect any failed banks with mechanisms in place to forcibly recapitalise banks within a six month time-frame.
According to analysis by Moody’s, the results will likely show that up to 26 banks "have a heightened risk of needing extraordinary external support" in order to meet the targets. It is highly unlikely that any of the big banks will struggle and instead it will be the unlisted or savings banks, Germany’s state-owned regional and potentially some Greek banks. Analysts are expecting the number of failures to be between 10 -15 which would give this round of tests some credibility and reduce uncertainty, especially given the failure of Irish banks immediately after passing last year tests. More specifically, as noted by Credit Suisse, 5 or 6 Spanish savings banks may need as much as EUR 12bln from the Spanish bailout fund FROB. This assumption was also confirmed earlier in the week after the finance minister of Spain said that some financial institutions will likely fail the tests, with recent early leaks to the press suggesting that up to 5 Spanish savings banks have failed. It is interesting to note that by a wide margin Spain is testing the most banks, 21 in total.
Looking elsewhere, UK banks are expected to encounter no problems due to their relatively high capital levels, but as with other big banks the attention will fall on their exposure to peripheral Europe which has seen a rise in borrowing costs in the inter bank market, with the 3-month EURIBOR above its 2-year high. On the other hand, the TED spread remains contained as there is no indication that banks are struggling to borrow money to finance their short-term obligations. In addition to that, despite the fact that the ECB only recently raised its benchmark borrowing rate it maintained its stance that it will continue to provide liquidity via MROs and LTROs. Nevertheless, in order to please investors over the future stability in the Eurozone, and given the level of inter-dependence within the banking sector across Europe, results will need to be exceedingly comforting.