Focus on AQR & Stress test 

 

 

Looking back through history (for more details, read the ECB lending survey, january 2015)

 

In contrast to the United States in 2008 and the Nordic countries in the early 1990s, euro area bank balance sheets were not rapidly cleaned up after the onset of the crisis, despite substantial public aid to many banks. Stress tests were not sufficiently credible and there was forbearance by some national supervisors (Schich and Kim, 2013). Weak bank balance sheets are potentially sustaining doomed companies and impeding reallocation of credit to new activities.

 

In October 2013, the EU regulation creating the SSM was adopted. The ECB will take on supervisory responsibility for the banking sector in the euro area and in those EU states outside the euro area that will join the SSM. The ECB is scheduled to take on the responsibility for the direct supervision of roughly 130 large banks as of November 2014. 

 

The new supervisory regime will be preceded by a comprehensive assessment of banks’ balance sheets in 2014, including a supervisory risk assessment, an asset quality review (AQR) and a stress test. This process is to ensure that banks will be assessed on the basis of a common methodology, for instance on non-performing loans, and to end the uncertainty surrounding the different approaches taken by national supervisors. 

 

 

The AQR & stress test results

 

The European Central Bank, which tested the eurozone’s biggest bank, said 25 lenders had failed and that the total capital shortfall is €24.6 billion. Taking account of capital raised this year, the shortfall shrinks to €9.5 billion. (WSJ)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The Peterson Institute for International Economics analyses the AQR results (here is an abstract of its study):

 

The figure below shows the data for those euro area banks that are close to the 5.5 percent limit on a fully loaded CET1 basis in the adverse scenario in 2016 and had a leverage ratio close to 3 percent, following the effects of the asset quality review. The size of bubbles illustrates the size of the bank’s balance sheet, and yellow banks had capital shortfalls under the comprehensive assessment’s definition of capital.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

CET1=Common Equity Tier 1

Source: European Banking Authority , European Central Bank    

 

The figure illustrates how under a fully-loaded CET1 capital definition (Y-axis), many more banks would have failed the comprehensive assessment, including noticeably several German banks like WGZ Bank, DZ Bank, HSH Nordbank, and LBBW (at 5.47 percent). Four more Italian banks would also have failed, as would two Austrian, a Spanish, a Belgian, a Dutch, and an Irish bank. Thus many more banks beyond those that failed the stress test are likely to need new capital under the new rules. Unless markets and the ECB put pressure on these banks quickly, they risk becoming the new euro area zombie banks. 

 

It also highlights how some other euro area banks—noticeably the giant Deutsche Bank—will face trouble in adhering to a 3 percent leverage ratio (X-axis). Were the leverage ratio to be increased from 3 to 4 percent, a number of very large Dutch and French universal banks would also be affected.

 

These data, published in conjunction with the comprehensive assessment but not part of the actual review, reveal the vulnerabilities in the euro area banking system well beyond the 25 failed banks. Forward-looking bank equity markets will likely force these banks to raise more capital, with the encouragement of the new ECB supervisor.

 

 

Judging the AQR & stress test credibility.

 

For Thorsten Beck, while this process had clear shortcomings, it still constitutes a huge improvement over the three previous exercises in the EU. 

 

• This assessment was a top-down approach – driven and monitored by the ECB – that focused on creating a level playing field in asset valuation and stress testing across banks in the Eurozone.

 

• By combining the asset quality review with the stress tests it increased the transparency and reliability of the stress tests.

 

However, there are also clear shortcomings:

 

• The stress test still does not include the scenario of a sovereign default.

 

• It does not include the adverse scenario of deflation, an issue that was less of a concern when the stress test scenario was developed earlier this year.

 

• It focuses exclusively on the risk-weighted capital–asset ratio and not on the leverage ratio. Fourteen of the 130 banks before the AQR, and 17 banks after, are below the 3% leverage ratio, and that does not take into account yet the effect of the stress tests. (see also Viral Acharya, Robert Engle and  Diane Pierret)

 

Viral Acharya and Sascha Steffen suggest that regulatory stress test outcomes are potentially affected by the discretion of national regulators. Their own analyses found possible capital shortfalls between €80 billion and more than €700 billion depending on the model.

 

Will the comprehensive assessment save the euro area economy?

 

By itself, the comprehensive assessment is unlikely to spur growth in the euro area, though some financial market fragmentation should be eased. Accordingly, the comprehensive assessment will prove a necessary but not sufficient exercise to restore sustainable growth and job creation (The Economist).

 

 

For more details about AQR & Stress test, read the WS Blogspot (October 27, 2014).