Bank stability risk is higher than EBA’s stress tests suggest

The EBA’s stress tests don’t stack up – allow ECR to enlighten you

The EU-wide stress tests for 2018, published by the European Banking Authority (EBA) early in November, are an attempt to assess the resilience of banks to a common set of adverse shocks on common equity tier-1 (CET1) ratios at 48 banks, accounting for 70% of total EU banking-sector assets.

The estimated CET1 capital ratios for 2020 are partly consistent with sovereign ratings, showing very good resilience for Dutch, Danish and Swedish banks, good resilience for Belgian banks, and intermediate resilience for those in Italy and Spain.

Euromoney does not believe these tests to be an especially constructive assessment, and country risk expert Norbert Gaillard agrees.

“The basic assumptions used are excessively optimistic,” says the independent sovereign risk analyst.

“There is no analysis of contagion [the term does not even appear in the 60-page report], and the EBA’s analysis in terms of sovereign exposure is questionable, with systemic banks’ ratings enhanced because there is an implicit sovereign guarantee.”

Further, it should be noted the tests do not look at banks in all member states. Neither are they produced frequently – an annual assessment is provided, which is already dated – or cover the myriad variables affecting bank stability.

[Vulnerabilities at Barclays and Lloyds] could become a major concern in the case of a hard Brexit 

 – Norbert Gaillard

Euromoney’s more holistic approach attempts to get around these issues, even if its risk survey is not intended to measure individual bank risk.

It is not a perfect substitute.

However, the reason the risk-scoring approach works is down to the fact it aims to assess overall stability for the sector, includes all countries and enables analysts to take into account more factors than the EBA tests consider.

For instance, the survey allows participating experts to quantify perceptions of regulatory risk, trading exposures, non-performing loan (NPLs)/asset quality and under-capitalization, along with any other relevant factors, including the growing threats of cyber-attack and money laundering or terrorist financing.

Note the fact losses from “conduct risk”, such as money laundering and market manipulation, account for two-thirds of all losses caused by operational risks in the EBA’s assessment.

“That’s disturbing and would deserve more development,” says Gaillard.

Euromoney Country Risk (ECR) bank stability scores do not provide a complete answer, but are assessed jointly with other relevant risk indicators, including a range of political and economic factors influencing whether or not a new banking crisis is more (or less) likely to occur.

These factors include policymaking, corruption and capital access, alongside standard measures of economic performance, with the changes in risk scores evaluated regularly, each quarter, rather than waiting for an annual update from the EBA that is flawed from the outset.

Based on the results of three quarterly surveys undertaken this year, nine of the EU’s 28 member states have witnessed deteriorating bank risk scores, including Germany, France and Portugal.

Italy is not among them, but the score is merely stabilizing at a low level after a sharp decline last year flagged concern.

Of the nine countries that have shown worsening score trends during the past five years, Luxembourg, the UK and Germany stand out.

This dovetails with EBA observations about vulnerabilities at Barclays and Lloyds “which could become a major concern in the case of a hard Brexit”, says Gaillard, and the under-performance of German banks, such as Deutsche Bank and various regional lenders.

Comparing the Q3 2018 survey scores – the latest available – with those prevailing in 2010 in the wake of the global financial crisis and sovereign debt defaults, all 28 countries remain riskier, and the five countries with the biggest score declines are Slovenia, Italy, Greece, France and Ireland.

Scores for all 28 countries are lower than they were in 2010, despite moves to bolster capitalization and liquidity requirements, indicating analysts are not confident that these arrangements alone sufficiently protect the region against another crisis developing.

This conflicts with the confidence of Mario Quagliariello, director of economic analysis and statistics at the EBA, stating: “The outcome of the stress test shows that banks’ efforts to build up their capital base in the recent years have contributed to strengthening their resilience and capacity to withstand the severe shocks and material capital impacts of the 2018 exercise.”

That may be so based on the assumptions used, but it cannot hide the fact there are notable vulnerabilities.

Indeed, scores from Euromoney’s latest Q3 2018 survey indicate there are 12 banking domains with risks that could be described as ‘not-insignificant’, all scoring less than 6.00 points on a scale of 1 to 10, where the highest number represents the lowest level of risk.

Understandably, Greece is bottom of the scale, on a score of 2.89, exhibiting severe risk, with an average NPL ratio of 50%, and requiring more than €2 billion of fresh capital.

This is putting shareholders at risk of enormous losses as authorities implement measures to resolve the problem.

Next up on Euromoney’s scale are Ireland (on 4.23 points), Spain (4.57) and a raft of other moderate concerns, including Hungary, Romania, Portugal and Italy, which has the highest bank stability risk score among the largest and most systemically important banking sectors in Europe.

This highlights an NPL problem that remains three times as large as the European average and the risk of higher market borrowing rates from increased bond yields, the Bank of Italy (central bank) pointed out recently.

One thing that neither the EBA report nor the ECR survey indicates is what would happen if any banks were to encounter difficulties, including the big question as to how policymakers such as the ECB would react in the event of a financial crisis.

But to know that a crisis is looming, and in which country the risks are highest, ECR’s survey would appear to have the edge. That’s true not just for Europe, but worldwide, as the bank stability indicators are regularly reviewed by analysts for 186 countries.