25 European banks fail stress tests

Banking stress tests in Europe have a rocky history. While the tests conducted by the United States Federal Reserve in 2009 restored confidence in the financial sector, European tests have been undermined almost immediately by bank failures. Stress tests in 2010 gave a clean bill of health to Ireland’s two biggest banks just months before the Irish banking system fell apart, requiring widespread bank bailout. In mid-2011, Belgium’s Dexia passed stress tests only to be rescued for the second time shortly thereafter.

The latest eurozone bank stress tests, the results of which were released on October 26, represent even higher stakes. 130 banks were examined, accounting for 82% of total banking assets in the euro area, and 25 of them failed, according to the European Central Bank (ECB).

EU-bankfailuresIt is FSG’s view that this round of stress tests has gone a long way to improving the eurozone financial system. The success of the tests is important not just for improving bank lending, but also because it helps move Europe toward creating a financial system in which lenders are judged by their own creditworthiness rather than that of their governments. The ECB will take on regulatory responsibility of eurozone banks on November 4, creating a single supervisor and common framework for winding down failed banks and taking important steps toward breaking the toxic link between banks and their governments. This is a good first step, but is only the beginning of a sustained period of deleveraging that will be required before Europe’s twin banking and sovereign debt crises wane.

In the meantime, however, eurozone businesses will continue to struggle as low supply of loans — a result of the sluggish pace of deleveraging — and low demand for loans — a result of slowing growth and geopolitical uncertainty — exacerbate the region’s vicious credit cycle. Companies should proceed to engage their customers and partners to ensure that they have the financing they need to buy and distribute their products. Companies should also manage their expectations for growth next year. While breaking Europe’s credit cycle could result in improved bank lending and growth in subsequent years, 2015 will be another year of deleveraging and adjustment, further dampening Europe’s growth outlook.

The results of the bank stress tests were better than expected, but are not the last word on Europe’s financial sector health

The results of Europe’s bank stress tests were better than expected, with the biggest shortfalls found in Italy, Cyprus, and Greece, and a relatively small capital gap of €25 billion compared to a €25 trillion euro area financial sector. Bond and currency markets have been relatively apathetic to the news. The largest capital hole to fill is Italy’s Monte dei Paschi di Siena, which is €2.1 billion of capital short of requirements. The comprehensive assessment, which consisted of an asset quality review and a forward-looking stress test of the banks, found an additional €136 billion in non-performing exposures across Europe’s banks, which will be written down. Failing banks will have two weeks to plan for these necessary adjustments, and then will have nine months to complete the adjustments that would move them into “safe” territory.

eurozone-capitalshortfallHowever, when expanding the list of troubled banks to those who barely passed the tests, four of Germany’s largest banks join the list. Indeed, many analysts and investors are already citing disappointment that the ECB didn’t take the opportunity to get more banks to thicken their capital cushions. Since the announcement of the exercise in July 2013, the largest 30 participating banks have undertaken measures to raise capital and strengthen their balance sheets. While this resulted in a successful outcome of the stress tests, the subsequent contraction of lending to businesses and households makes it unlikely that banks will both lend and maintain capital in the upcoming years.

One key flaw of the stress tests was that they left it up to the banks to assess their own risks, which resulted in certain national discretions. These national discretions can lead to differences in, for example, the definition of capital. While these differences will gradually diminish over the coming years as transitional arrangements in the relevant regulation are phased out, they lead to distrust in the results. This is particularly true for German banks, where implicit but unrealized national guarantees of much German debt saves the landesbanken from otherwise severe capital shortfalls. Furthermore, Greek banks rely on deferred tax assets to make up an unhealthy chunk of their capital – approximately a €11 billion commitment across four banks that the Greek government cannot afford.

Still, the breadth and depth of the stress tests are a positive step, making the assessment more rigorous and more uniform than before. Recapitalization has already occurred on a large scale. And, the likelihood of an unexpected shock after the tests is somewhat smaller than before as a result of reduced uncertainty over which banks will fail. In short, the results are credible, but only the beginning of a much longer sequence of deleveraging that will extend well into 2015.

The vicious credit cycle will not be broken in 2015, muting expectations for growth in the region

Unfortunately for Europe, the results of the stress tests alone will not end the ongoing credit crunch for small and medium-sized companies. Even banks that will not be required by the ECB to raise additional capital will find themselves under market pressure to do so, particularly those whose asset values had been deemed overly optimistic by the tests. As the key leading indicator for improvement in the eurozone’s health, the continued contraction of bank lending will hold down economic growth in 2015, and continue to place downward pressure on price growth.

The second factor weighing on eurozone growth next year will be demand for credit. As major eurozone economies grind to a halt and geopolitical risk accentuates operational uncertainty, businesses are not keen to hire extra workers or make additional investment. If investors decide that this round of stress tests was still too easy for banks to pass, it could add to an already uncertain environment, reducing demand further.

In the wake of stress tests results, banks’ stock prices will rise, and we could see a wave of consolidation as concerns about skeletons lurking in banks’ closets are eased. However, for the 85% of European businesses that rely on bank lending for their financing, today’s results were not remarkable news. In a separate look at 300 big banks in industrialized countries by the IMF, 40% of the banks were found to be in a position where lending was not economically feasible. This is especially true, and especially dangerous, in Europe. Multinationals should continue to ensure that their partners and customers will have access to the capital they need to purchase and distribute their products. And as for economic growth, 2015 will be another disappointing year.

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