EU Stress Test Features Bond Rout, Eastern Europe Shock

The strength of Europe’s banking system is about to be tested against a fictional doomsday scenario that includes a global bond rout and a currency crisis in central and eastern Europe.

The three-year outlook features “the most pertinent threats” to the stability of European Union banks and their potential impact on entire balance sheets, according to a draft European Banking Authority statement seen by Bloomberg News. The EBA is due to release the details tomorrow in coordination with the European Central Bank.

As the ECB prepares to take over supervision of about 130 euro-area lenders from BNP Paribas SA to National Bank of Greece SA starting in November, policy makers have chosen to reflect real-world developments like the tensions over Ukraine in a bid for more credibility in the toughest stress tests to date. Similar exercises in 2010 and 2011 were criticized for failing to uncover weaknesses at banks that later failed.

“The negative impact of the shocks, which include also stress in the commercial real estate sector, as well as a foreign exchange shock in central and eastern Europe, is substantially global,” the draft statement said. “For most advanced economies, including Japan and the U.S., the scenario results in a negative response of GDP ranging between 5-6 percent in cumulative terms compared to the baseline.”

‘Nightmarish Scenario’

Bloomberg News reported on April 25 that the total impact of the shocks on gross domestic product will be equivalent to 7 percentage points of growth below European Commission forecasts over the three years through 2016.

“It is indeed a nightmarish scenario, but we have to cope with it,” Charles Borg, chief executive officer of Bank of Valletta Plc, said by e-mail. “We expected the forthcoming stress test to be tougher than the previous ones, and we have been preparing for it. What is adding to the uncertainty is the fact that the results of the asset-quality review will be the opening balance of the stress test.”

The stress tests are the third part of the ECB’s year-long assessment of euro-area banks. Officials have claimed its credibility will be enhanced by a preceding asset-quality review that aims to uncover the true state of lenders’ balance sheets. An EBA spokesman declined to comment on the details of the scenarios because they will be published tomorrow. An ECB spokeswoman declined to comment.

Capital Buffers

The exercise, which will examine a sample of 124 banks that cover more than half of each EU member state’s banking industry, is scheduled to begin around the end of May, while results will be published at the end of October.

As a pass-mark for the base scenario, which uses EU growth and unemployment forecasts through 2016, banks have to be able to maintain a capital-to-risk-weighted-assets ratio of 8 percent. In the so-called adverse scenario, where lenders are allowed to run down loss capital buffers, the ratio is 5.5 percent.

That adverse scenario contains “a sovereign shock that impacts banks’ entire balance sheet including exposures held in the available for sale portfolio via the internationally agreed gradual phase-out of prudential filters,” the draft statement said. In addition, it represents “a shock to banks’ funding costs that pass through to the asset and liability side in a conservative asymmetric fashion.”

Imagining Events

The imaginary downturn is caused by events including investors shunning emerging markets, downgrades of debtors in countries already hit by recession, stalling reforms that cast doubt on public finances, and a halt to the repair of bank balance sheets.

“Sharp increases in worldwide bond yields following an abrupt reassessment of risk is currently the main financial stability risk facing the European financial system,” ECB Vice President Vitor Constancio said at an event in Frankfurt today.

Sentiment towards “emerging markets has turned more negative,” he said “Both the resulting compression of spreads in several European asset classes and the the heightened sensitivity to the developments especially in Ukraine and Russia further increased risks of an disorderly unwinding of recent trends.”

The scenario includes “a static balance sheet assumption, which precludes any defensive actions by banks, prescribed approaches to market risk and securitization, and a series of caps and floors on net interest income, risk-weighted assets and net trading income,” according to the draft statement.

Two-Year Recession

Combined, those events cause growth to undershoot forecasts by 2.2 percentage points in 2014, 3.4 points in 2015 and 1.4 points in 2016. The EU currently forecasts growth in the 28-nation bloc of 1.5 percent this year and 2 percent next year, meaning the scenario probably translates into two years of recession followed by anemic growth in the final year. The EU hasn’t released a forecast yet for 2016.

“Those details imply the EBA will stress banks with a 360-degree approach, including any kind of possible risk on their balance sheets,” said Fabrizio Bernardi, a Milan-based banking analyst at Fidentiis Equities. “It’s more complex and tougher than the 2011 test, which considered only a shock on sovereign debt.”

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