Photographer: Martin Leissl/Bloomberg

European Bank Stress Tests Get More Stressful When You Make Them American

The answers you get depend on who is asking the questions.

The European Banking Authority's stress tests released on July 29 served as a key plank in the region's effort to publicly demonstrate to markets and regulators around the world that its banking system is on the mend.

But while the Stoxx Europe 600 Bank Index is up 2.79 percent since the results were announced, markets remain skeptical about the health of lenders in the region given the still low equity prices. The sector is trading at 0.64 times book value, compared with 0.85 at the end of last year, while non-performing loans continue to erode bank capital.

What gives?

The EBA stress test of 51 lenders in the region initially came in for heavy pounding by critics citing the fact it didn't factor in sovereign defaults, the impact of Brexit, and a prolonged period of negative interest rates. But two recent independent studies are particularly instructive as they reveal the drawbacks of the ECB stress test, using the methodology and disclosures made available by the EBA itself. The studies reveal why, thus far, European policymakers are failing to sow the seeds of market confidence in systemically important lenders.

In short, the European stress test reflects a bank's ability to remain solvent during market shocks — which are, in some respects, more benign than those in the U.S. and U.K. tests — as judged against their prudential regulatory requirements. By contrast, using market-based measures of economic viability highlight how European lenders are much less healthy than EU policymakers assert.

Stephen G. Cecchetti, former economic advisor at the Bank for International Settlements, and Kermit Schoenholtz, economics professor at New York University, explained the shortcomings of the EBA stress test in a blog post this week.

They believe that the EBA stress test — which imposes a three-year stimulated stress episode that sees equity prices drop by 25 percent — fails to reflect true market-based risks. They argue that the economic growth, share-price falls, and property-price assumptions used by the EBA are too benign relative to their regulatory peers in the U.K. and U.S. "While these banks may meet a weak regulatory test, as the more than 40 percent decline of bank equities over the past year implies, they do not meet the market test," they write.

This criticism is consistent with a new research paper published by academic economics Viral V. Acharya, Diane Pierret, and Sascha Steffen. Based on the disclosures made available by the EBA stress test, they estimate that European banks face a capital shortfall of 123 billion euros, when set against U.S. supervisory standards and a 4 percent leverage ratio — also known as a capital-to-asset ratio, a measure that determines how much capital a lender needs to set aside relative to the assets they hold. (The U.S. supervisory approach is known as the Comprehensive Capital Analysis and Review, CCGR.)

Acharya, Pierret, Steffen

However, the equity shortfall is considerably larger when subject to a 5.5 percent leverage ratio and a 40 percent decline in global stock markets, using a systemic risk (SRISK) measure first designed by the Volatility Institute at the New York University Stern School of Business. On this basis, they estimate that the 34 publicly listed banks in the EBA stress tests would face a capital shortfall of 640 billion euros.

Cecchetti and Schoenholtz also combine data from different supervisory sources and use the aforementioned SRISK measures to highlight the market value, rather than the book value of equity. Under a more adverse market-based stress test than the one set by the EBA, they conclude that several large European lenders would need to raise between $24 billion and $40 billion each just to fulfill the modest 3 percent leverage requirement set by the European authority.

"These studies identify large shortfalls that likely do matter; unfortunately none of these shortfalls are a surprise to me," says Martien Lubberink, a regulatory capital expert. "But it's unfair to devise a test where you know lenders will struggle with because their capital starting point is already modest. Prudential supervisors rely on accounting measures, rather than market measures, while European supervision focuses on risk-weighted assets, rather than the leverage ratio, as the threshold for capital adequacy."

The significance of these studies that are more sympathetic to the U.S. supervisory tradition — which focuses on market values of equity and the leverage ratio — shouldn't be understated. European Union policymakers are jockeying against a U.S.-driven push for stronger capital rules with respect to bank leverage, trading books, and the use of internal models for risk assessment, a move that has been dubbed a new Basel IV accord.

"There is a very live debate on the finalisation of the Basel rules (or Basel IV as it is commonly known); this is due to finish by the year-end," HSBC Bank Plc analysts, led by Robin Down, wrote in a report last week. Referring to the EBA stress test, they add, "By demonstrating the growing resilience of the sector, the stress test adds significant weight to the argument that the sector is already sufficiently well-capitalised."

But in a blow to EU policymakers, these independent stress tests, based on U.S.-style rules, demonstrate how the capital buffers of European lenders would be inadequate in the event of a significant market shock. In theory, this reduces the EU's leverage over the U.S. in crafting capital rules. 

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