Photographer: Alessia Pierdomenico/Bloomberg

Europe Bank Stress Tests May Spoil Spread Compression: Analysis

The results of Europe’s latest health check on its lenders may cast the spotlight on Italy’s banking troubles, sparking political volatility in the country and stalling a narrowing of continental bank bond spreads, Bloomberg strategist Simon Ballard writes.

The European Banking Authority’s stress-test results on the 51 largest euro-area banks should be released around 9 p.m. London time on Friday. The EBA may not give out pass or fail marks, but its conclusions will be scrutinized for any evidence of persistent structural capital deficiencies across the euro-area banking sector.

European bank spreads have narrowed significantly after the Brexit-fueled widening in late June. The iTraxx capital-structure curve has flattened to around 114 basis points from a high of 180 basis points in February. However, in peripheral euro-area bank debt, Italian names have noticeably lagged Spanish peers in recent months. UniCredit SpA’s so-called additional Tier 1, or AT1, bonds have underperformed and have been much more volatile than similar securities of Banco Santander SA. There has also been a similar underperformance between the sovereign bonds of the two countries.

Italy risks

Within the EBA results, particular focus may therefore be given to Italian banks and among them to Banca Monte dei Paschi di Siena SpA, owing to the latter’s status as the most vulnerable and the third largest of the nation’s lenders. Should the stress-test results highlight the need for new capital for Italian banks, the question of financial and political stability may be raised. In Italy, the subject of bank bail-ins is a contentious issue given the magnitude of the nation’s retail investor base and its exposure to subordinated debt instruments.

Italy’s finance minister has denied any need for a bail-in of bondholders in local banks, but the key question will be to what extent private investors might be willing to help raise new capital without government bailout funding. In this respect, Adepp, the Italian pension funds association, is backing a new fund of as much as three billion euros, to be known as Atlante 2, to support banks, according to a statement published on the group’s website.

Casting a spotlight on capital shortfall at banks through the stress-test results may also have adverse implications for the broader credit markets. Any shift to a more defensive investor sentiment could steepen the capital-structure curve across European banks as retail investors reduce their subordinated-debt exposure.

Moreover, political uncertainty could increase in Italy ahead of the nation’s scheduled referendum on constitutional reform later this year and growing support for the populist Five Star Movement could weaken the current government. As such, a longer-term, systemic solution to the Italian debt and bad loan problems may be necessary to avoid a negative impact on the already disappointing economic recovery. But this may only materialize after 2016, following the Senate reform vote.

EBA stress-test methodology 

The EBA 2016 stress test will use a common methodology to assess solvency and cover all main risk types. The results will be used to inform the Supervisory Review and Evaluation Process (SREP).

Risk types covered by the tests will include credit risk and securitization, market risk, sovereign risk, funding risk and operational and conduct risks. The tests will run on the banks’ models and the results will then challenged by supervisors in the relevant competent authorities.

To ensure consistency, the methodology contains key constraints such as a static balance-sheet assumption, which precludes any mitigating actions by the banks, and a series of caps and floors: for example, on risk-weighted assets and net trading income.

Note: Simon Ballard is a credit strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice.

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