European Banks Stress tests of the last 29th of July

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On the last 29th of July EBA (European Banking Authority) conducted the stress tests on 51 European banks. First, we have to record what EBA is: the European Banking Authority is a regulatory agency of the European Union; EBA has the power to overrule national regulators if they fail to properly regulate their banks.

The EBA is also able to prevent regulatory arbitrage and should allow banks to compete fairly throughout the EU. Its activities include conducting stress tests on European banks to increase transparency in the European financial system and identifying weaknesses in banks’ capital structures. The stress test is an analysis conducted under unfavorable economic scenarios designed to determine whether a bank has enough capital to withstand the impact of adverse developments. The stress test is called also Scap (Supervisory capital assessment program), that is to say an assessment of capital conducted by to determine if banks had sufficient capital buffers to withstand the recession and the financial market turmoil.

The test use two macroeconomic scenarios, one based on baseline conditions and the other with more pessimistic expectations, to plot a ‘What If?’ exploration into the banking situation in the next years. Italy’s Monte dei Paschi, the UK’s Royal Bank of Scotland and Ireland’s Alied Irish Banks emerged as the biggest losers in this last stress tests, which anyway found that the region’s top 51 banks had enough capital to withstand another financial crisis.

So banks from Italy, Ireland, Spain and Austria fared worst in the test.

None of the four UK banks – Lloyds and HSBC were also tested – dropped below the legal minimum of 4,5% capital ratios. Unlike previous tests, the last July stress tests do not give banks a pass or fail designation, and instead the Eba intends the results to be used by national banking regulators for the purpose of measuring and bolstering lenders’ financial resilience.

Should the test have included a pass or fail mark, it is obvious the Monte dei Paschi di Siena would have failed by a substantial margin. Yes, because Monte dei Paschi di Siena, the stricken Italian lender, would be insolvent in less than three years under an “adverse scenario”. The results showed that the Italian bank had the biggest deterioration in its key capital ratio, the so called fully loaded common equity tier one (CET1) ratio, which takes into account new regulations due to come into force in the near future.

Monte dei Paschi di Siena CET1 ratio fell by 12,01% against the previous test, leaving Italy’s third largest lender with a ratio of -2,23%, suggesting that the bank would become insolvent in the event of a substantial economic shock over the next three years. Aside for Monte dei Paschi di Siena, Irish lender Allied Irish Bank had the second biggest fall in its fully loaded CET1 ratio.

AIB’s ratio fell from more than 13% at the last reading, to just 4,31% this year. That makes the Irish government’s hopes of reprivatizing the bank over the coming years more distant because the headline figure is like to spook investors, even though it penalizes the banks under some rules the will not come into effect until 2022. The UK is in a similar situation with RBS, which had the third biggest fall in CET1 ratio falling from 115,89% to 8,08% in the adverse scenario.

Barclays also emerged in a relatively weak position with a fully loaded CET1 ratio that fell from 11,4% to 7,3%. Anyway the general framework is by far better than expected and for sure the results show improvement of the European banks’ resilience from 2014, but, as Andrea Enria (the EBA chairman) said, “this is not a clean bill of health. There remains a lot of work to do”.

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