Banks Can't Fail as Europe Rolls Out Post-Crisis Stress Test

  • Adverse scenario foresees EU recessions this year and next
  • EBA sets no pass mark because banks in `steady-state setting'

Europe’s biggest banks face a stress test this year that will gauge their capacity to withstand economic contraction at home, shocks in major emerging markets and declines in property markets and commodities. None of them will pass -- or fail.

QuickTake Stress Tests

The test has no pass mark to identify capital shortfalls, a break from previous practice, because banks have emerged from the financial crisis, the European Banking Authority said. Supervisors such as the European Central Bank and the Bank of England will factor the results into their annual assessments of lenders. Both have said the industry is well capitalized and they won’t be imposing significant new capital requirements.

The adverse scenario for this year’s health check, published on Wednesday by the London-based EBA, exposes banks to recessions in the European Union this year and next followed by anemic growth in 2018. It assumes gross domestic product rising 3.4 percent in China this year, compared with a baseline projection of 6.5 percent. In Russia and Brazil, 2016 GDP plunges 8.1 percent and 5.9 percent, respectively.

“These stress tests should have limited impact on the banks’ capital plans,” KBW bank analysts said in a research note after the EBA publication on Wednesday. “These scenarios are not that far from the fears priced in today in bank valuations.”

Capital Buffers

Commodity prices also take a hit in the EBA’s adverse scenario, with oil prices down about 48 percent this year from the baseline projection of about $54 a barrel. Brent crude for April settlement lost as much as 56 cents, or 1.6 percent, to $33.85 a barrel Thursday morning on the London-based ICE Futures Europe exchange. Prices remain about 44 percent below baseline levels in 2017 and 2018 in the EBA test.

The scenario projects that long-term interest rates in the EU would be higher by 71 basis points in 2016, 80 basis points in 2017 and 68 basis points in 2018. Meanwhile, the test includes an overall decline of 6 percent in house prices, a supplemental shock of 7.5 percent affecting all EU countries and additional house-price declines in Denmark, Ireland and Slovakia.

In 2014, to pass a baseline scenario, banks had to maintain a ratio of capital to risk-weighted assets of 8 percent. In the adverse scenario, which allowed lenders to run down capital buffers, the ratio was 5.5 percent. Twenty-four banks failed that test with a capital shortfall of 24.6 billion euros ($27.1 billion).

Capital Shortfalls

“The objective of the crisis stress tests was to identify possible capital shortfalls and require immediate recapitalization actions,” the EBA said. “As banks have now moved to a more steady-state setting, the aim of the 2016 exercise is rather to assess remaining vulnerabilities and understand the impact of hypothetical adverse market dynamics on banks.”

The 51-bank exam, whose results will be published early in the third quarter, comes after banks including Societe Generale SA, HSBC Holdings Plc and Standard Chartered Plc reported disappointing earnings that raised questions among investors and regulators about lenders’ ability to make a profit.

“Since the start of the year we have seen investor concern about lenders’ high level of debt, exposure to the oil and gas sector with falling commodity prices and the slowdown in growth in China,” said Edward Chan, partner at Linklaters LLP in London. “The stress tests are designed to ensure that banks have a sustainable business model in the face of such turbulence.”

Daniele Nouy, head of the ECB’s oversight arm, said on Feb. 23 that her chief priority in 2016 is reviewing how lenders are changing their business models and investing in riskier assets to ensure they can remain profitable.

The ECB and the BOE have said this year that the industry is well capitalized and they won’t be imposing significant new capital requirements. Nouy said it’s not the ECB’s intention to raise capital requirements indefinitely. With regard to bank-specific requirements set by supervisors, “we expect the banks to hold in steady state,” she said. “All things being equal, supervisory requirements will not be increased further.”

Even without the threat of capital gaps being revealed, stress tests are useful to “keep banks on their toes a bit,” said Robert Montague, senior financials analyst for ECM Asset Management, part of Wells Fargo Asset Management which has $490 billion under management. The assessments are “a good thing in that they make comparable data available across the piece,” he said.

The EBA said the data from the tests will help regulators supervise individual lenders, “where mitigating actions may also be considered.”

This year’s test pits banks’ end-2015 balance sheets against a common macroeconomic baseline and an adverse scenario. It includes banks from 15 countries and covers about 70 percent of the industry by total consolidated assets as of end-2014.