Banks Brace for European Stress-Test Results on July 29: Q&A

The European Banking Authority will release the results of its latest stress test at 9 p.m. London time on July 29. The exam is intended to give supervisors across the 28-nation European Union a common basis for measuring and bolstering lenders’ financial resilience. In a break from past practice, the test has no pass/fail mark and won’t specify capital shortfalls.

The publication has taken on additional importance this year because of its connection to Italy’s attempts to shore up banks weighed down by about 360 billion euros ($396 billion) of non-performing loans.

Which banks are covered?

Fifty-one banks with a minimum of 30 billion euros in assets and representing about 70 percent of total EU bank assets. That’s down from 123 banks in the 2014 exercise. The EBA said it “decided to focus on a more homogeneous sample of large banks to ensure greater comparability.” Smaller banks will be tested separately by their supervisors as part of the review and evaluation process.

Five Italian banks are in the list, including Banca Monte dei Paschi di Siena SpA, a focus of state-aid discussions between the European Commission, the EU’s executive arm, and the government of Prime Minister Matteo Renzi. Monte Paschi failed the EBA’s 2014 test with a net capital gap of 2.1 billion euros.

What information will be published?

The EBA published about 12,000 data points per bank in 2014, and should match that level of granularity this time around, including capital positions, risk exposures and sovereign-debt holdings. The regulator will also release a report with aggregated data.

For a Bloomberg Intelligence report on the stress test, click here.

What does the test consist of?

The exam is carried out on the basis of end-2015 data. Banks are measured against two scenarios, baseline and adverse, covering the three years through 2018.

The European Commission’s autumn 2015 forecast provides the baseline macroeconomic scenario through 2017 for most variables. The 2018 baseline was “derived for the purpose of this exercise” and isn’t part of the official forecast, according to the Brussels-based commission.

The adverse scenario was developed by the European Systemic Risk Board, located in Frankfurt. This exposes banks to recessions in the EU this year and next followed by anemic growth in 2018. Commodity prices also take a hit, with oil prices down about 48 percent this year from the baseline projection of about $54 a barrel. It projects that long-term interest rates in the EU would be higher by 71 basis points in 2016, 80 points in 2017 and 68 points in 2018.

The test’s assumptions have come in for criticism given the current low-rate environment. The ECB, which on July 21 held its main refinancing rate at zero, forecasts rates “to remain at present or lower levels for an extended period of time.” On July 14, the Bank of England maintained its benchmark rate at 0.5 percent and signaled it’s readying stimulus for August as the economy reels from Britain’s decision to secede from the EU.

Why has the pass/fail format been scrapped?

In 2014, the EBA set two thresholds for banks’ common equity Tier 1, the highest quality capital: 8 percent of risk-weighted assets for the baseline scenario and 5.5 percent for the adverse. Twenty-four banks failed the test with a total capital shortfall of 24.6 billion euros.

This year’s test sets no capital hurdle, though CET1 ratios will be published. This reflects the post-crisis environment in which banks are in a “steady state” and capital requirements aren’t expected to rise, according to the EBA. “The aim of the 2016 exercise is rather to assess remaining vulnerabilities and understand the impact of hypothetical adverse market dynamics on banks,” the EBA said. 

What are the headline numbers?

In the absence of a pass mark, the CET1 ratios for banks under the adverse scenario will probably be the first thing investors and analysts look at. EU law sets a minimum CET1 requirement of 4.5 percent for banks within an 8 percent basic requirement for Tier 1 and Tier 2 capital. Banks also have to comply with buffer requirements that must be filled with CET1 capital, and with bank-specific demands set by supervisors, known as Pillar 2.

Monte Paschi, for example, recorded a CET1 ratio of minus 0.1 percent under the adverse scenario in 2014. Last year, the ECB set Monte Paschi a CET1 ratio requirement of 10.2 percent for 2016, rising to 10.75 percent at year-end.

How will the results be used?

The stress-test outcomes will feed into supervisors’ review and evaluation process of the banks, including setting the Pillar 2 bank-specific requirements. The baseline “obviously is part of the capital requirement assessment for Pillar 2,” Nouy said on July 13.

The results of the adverse scenario, by contrast, will feed into capital guidance. As this guidance isn’t binding, failing to meet it doesn’t automatically lead to restrictions under EU law on a bank’s earnings distributions, including coupon payments on additional Tier 1 debt.

Still, guidance is “very serious,” Nouy said. “I don’t expect banks to breach the guidance or to go below the guidance. We are in the steady state, and we have in mind the same level of capital in the system.”

What is the link with Italy?

The Italian government has been trying to find a way to shore up its struggling banks without imposing losses on investors. That’s difficult to do in the EU, especially under bank-resolution rules that came fully into force at the start of the year.

The Bank Recovery and Resolution Directive assumes that the need to give a bank “extraordinary public financial support” indicates that it’s “failing or is likely to fail,” triggering resolution. Yet the law also gives politicians an alternative for helping solvent banks.

When public support is used to address a capital shortfall identified in a stress test, this may not lead to resolution when it is needed to “remedy a serious disturbance in the economy of a member state and preserve financial stability.”

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