Schroders’ European Banks analyst Justin Bisseker looks at the results of the tests and some of the more subtle conclusions he expects the equity market to focus on
The weekend has seen much excitement for European bank watchers with the release of the conclusions of the Asset Quality Review (AQR) and stress test. Both parts of the exercise should be of interest to investors, although much of the media interest thus far has just been on who has passed and who has failed.
So, what has been done? Firstly, the European Central Bank (ECB) has conducted an in-depth review of bank balance sheets ahead of its taking the helm as the Eurozone’s banking regulator next month. This has certainly been a detailed process – far more so than any investor could reasonably undertake. More than 119,000 borrower files and 170,000 collateral valuations were reviewed across 130 Eurozone banks to ensure a uniform provisioning methodology and harmonised definitions. 18% of these credit files required some form of adjustment. These results were then extrapolated such that the majority of banks’ material portfolios were covered in detail. Banks are required to maintain a “phased” core Tier 1 capital ratio in excess of 8% post any required adjustments.
Second, the ECB (and the European Banking Authority for non-Eurozone banks) has stressed the banks (post any AQR adjustment) for severe macroeconomic stress (the “adverse scenario”) with banks required to maintain a 5.5% phased core Tier 1 ratio throughout. Cumulatively, this stress incorporated a 6.6% “shock” to Eurozone GDP spread over three years.
The results were as follows. The AQR identified €136 billion of incremental non-performing loans requiring aggregate adjustments of €34 billion to participating banks’ balance sheets as struck at end-December 2013. Combining this with the adverse scenario results in an aggregate capital impact of €263 billion – some 27% of capital held by participating banks and a median 400 basis point hit to Eurozone banks’ phased core Tier 1 ratios. These are big numbers, but the resulting shortfall against the 5.5% phased core Tier 1 requirement was €25 billion; just 2.5% of the Eurozone banks’ capital base. Taking into account capital already raised, the resultant shortfall is just €9.5 billion spread across only 13 banks.
Inevitably, the initial interest of the media and the market has been on simple pass/fail metrics with only Monte dei Paschi (€ 2.1 billion shortfall), Banca Carige (€0.8 billion shortfall) and BCP (€1.15 billion shortfall) impacted amongst the quoted banks. However, in time I would expect the equity market to focus on some rather more subtle conclusions.
Firstly, a number of banks have been found short of a provisioning level the ECB views as prudent. For almost all banks, these amounts are very manageable and the banks may argue that their provisions are sufficient (indeed, much may have been booked in 2014). However, as the ECB says: “It is expected that many banks will likely choose to reflect many of these changes in their accounts.” Investors will need to take note of these potential true-ups not least because if the banks do not book required provisions, it seems quite likely that the ECB will factor shortfalls into prudential buffers.
Second, the stress test has been conducted against phased core Tier 1 requirements. Investors should focus on “fully loaded” ratios – i.e. with full deductions for items such as goodwill, holdings in other banks, internal ratings-based provisions shortfalls and deferred tax assets. This is because this will be what ultimately dictates risk to share counts and the ability to pay dividends from 2019. On a fully loaded basis, nine out of 15 Italian banks tested would have failed to pass the 5.5% hurdle. This is important as investors will not want to cover a capital deficiency against today’s phased metric, only for the hat to be passed around again as regulation migrates towards fully phased requirements in 2019.
For the vast majority of the sector, however, we have passed an important milestone. Many of the listed banks should be able to transition to the sunny uplands of sustained book value growth and attractive dividend yields for equity investors. Regulators should also ask themselves how much capital banks really need to carry. With the overwhelming majority of the listed sector well able to navigate an adverse scenario, even on a fully loaded basis, one would hope that investors can look forward to sensibly struck regulatory requirements that allow banks to earn sufficient returns to attract investor capital and fully support a macro recovery in Europe.
European Banks analyst, Schroders