European bank stress tests draw a blank

In July the European Banking Authority (EBA) announced the results of the most recent stress tests on 51 major banks within the European Union (EU).  Oddly, there were no passes or failures; instead, what we got was a league table based on estimated Tier One capital and a series of shocks. The results were inconclusive and open to interpretation.

Under the 2016 stress tests, bank balance sheets were tested against the impact of a macroeconomic downturn over three years, in which real gross domestic product (GDP) would decline by 1.2% in the EU during 2016, fall by a further 1.3% in 2017 and recover slightly over the course of 2018.

The stand-out underperformers were, unsurprisingly, Italy’s Banca Monte dei Paschi di Siena (BMPS), (founded 544 years ago and Europe’s oldest bank); Royal Bank of Scotland (RBS); and Allied Irish Banks (AIB). More worrying perhaps was the poor outcome for some of Germany’s larger banks such as Deutsche Bank and Commerzbank.

The stress test results were supposed to reassure markets that the banks are strong enough to withstand a series of shocks. However, the reaction to the tests has been somewhat muted because of their inconclusive nature. A better indicator of the health of the banks is their share prices, which have been tumbling.

According to the EBA: “This data shows that profitability remains an important source of concern and a challenge for the EU banking system, in a context of continued low interest rates, high level of impairments linked to large volumes of nonperforming loans, especially in some jurisdictions, and provisions arising from conduct and other operational risk related losses.”

However there was a mixed reaction to the stress test results in the financial media:

The Economist magazine wrote in their print edition in reaction to the stress test results “any big announcement about banks made after the markets close for the weekend is bound to bring back dark memories of the 2007-08 financial crisis. Although the results of the latest European bank stress tests, released on July 29th, contained much that was reassuring, they did not dispel investors’ doubts about the industry’s earnings prospects.

“And in the case of Italy, the tests seemed to exacerbate bigger worries. When the markets opened again on August 1st, they were marked by falls in banks’ share prices; the Euro Stoxx banks index dropped by 3% and almost 5% on successive days….

“……These figures are flattered, however, by the absence of banks from the still-struggling economies of Greece, Portugal or Cyprus”.

The latter point is well made. What do we deduce about the condition of the banks in Greece, Portugal and Cyprus? How can you interpret data about the European banks which selectively excludes some of the worst performers for convenience?

The report has clearly not dispelled market concerns.

Italy

There is strong anecdotal evidence that bad loans are weighing down on Italy’s banks and are higher than reported. There has also been speculation that many Italian businesses are existing on life support with loan facilities being rolled forward by the banks at knock-down interest rates.

The Bank of Italy has reported non-performing loans of €360bn. The prospect of ‘bail-in’ beckons for bond holders under new European rules put in place following bank bail-outs in many countries which were funded by taxpayers. Many retail investors hold Italian bank bonds.

BMPS actually suffered losses greater than their capital base in an adverse scenario according to the test results, ending up with a negative Tier One ration of 2.44%. Unicredit’s corresponding score was positive at 7.10%, as was UBI Banca at 8.85%, Banco Popular at 9.0% and Intesa Sanpaolo which was stronger again at 10.21%.

In its assessment The Economist further concluded: “The fall in Italian bank shares extended even to those that performed well in the stress tests, such as Banco Popolare. One fear is that the bad-loan plan laid out by BMPS sets a new benchmark for the whole sector.

“Many Italian lenders still have provisions on impaired loans of below 20%, and value their non-performing loans at much more than 33 cents on the euro. If the BMPS deal does indeed set the standard for the rest, Italian banks could need up to €18bn more in capital, according to Autonomous, a research firm.”

Germany

There was huge focus on the German giants Deutsche Bank and Commerzbank. Poor financial results have dogged the major German lenders this year with massive declines in share prices. Both featured in the ‘worst performers’ list with Deutsche Bank at a 7.8% capital ratio and Commerzbank even further behind.

John Cryan, Deutsche Bank’s chief executive officer CEO has been in the media spotlight, with much of his focus trying to deal with the fallout from problems with regulators.

Ahead of business daily Handelsblatt’s Banking Summit to be held in Frankfurt on August 31 and September 1 titled, appropriately enough ‘Banks in Upheaval’, Cryan said that “monetary policy is now running counter to the aims of strengthening the economy and making the European banking system safer.”

He further elaborated that “the ECB’s policy is squeezing the margins of Europe’s struggling banks, making it harder for insurers to find profitable investments and dangerously distorting financial market prices. Given the continued uncertainty, companies are holding back on investments and are hardly seeking any credit anymore.”

Cryan finds it unacceptable that financial regulators demanded that banks increase their capital ratios but then imposed punitive interest rates on the additional reserves.

Impact of Brexit

The stress test results are pre-Brexit and it is too early to say what impact the UK’s exit from the EU will ultimately have on the banking sector. The impact of falling sterling interest rates will weigh heavily on the country’s banking sector. There is bound to be cost increases, with dual regulation by the Bank of England (BoE) and the European Central Bank (ECB).

Broader concerns will focus on the ‘corporate bonds bubble’ and significant corporate debt maturities over the next 18 months.

The overall sense is that solvency is less of an issue for the banks than it was, while bank profitability in a negative interest rate environment has become more of a concern. The traditional banking model is no longer sustainable and investors are likely to continue to dump bank stocks, unless there is more creative thinking by central banks and regulators.

Corporates must assess their banking relationships in a new light. Low and negative interest returns are challenging the treasury policies of many organisations. Corporate deposits continue to have a risk factor – albeit there is virtually no return or, in some cases, a negative interest rate.

Banks are likely to spurn higher risk credit and seek increases in bank fees to try and address the profitability gap. The disruptive effect of financial technology (fintech) adds further to the mix. There is no question that the banking landscape will change dramatically over the next five years and there will be losers as well as winners.