The ECB’s Comprehensive Assessment: What can we learn from the results?

On October 26, the European Central Bank (ECB) published the results of its Comprehensive Assessment. In this analysis, we show the main conclusions from the assessment and analyze the determinants of the results. Based on these findings, we discuss what conclusions can be drawn for banks.

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The ECB’s Comprehensive Assessment
What can we learn from the results?

Executive summary: Key findings and implications
 On October 26, the European Central Bank (ECB) published the results of its Comprehensive Assessment of the 130 largest banks in the Eurozone, consisting of an Asset Quality Review (AQR) and a Stress Test. The Stress test was executed together with the European Banking Association (EBA) and included another 20 non-Eurozone banks  Strategy& analyzed the published results and combined them with available bank- and country-specific information  On first sight, the impact of the Comprehensive Assessment is relatively limited, with €7Bn additional capital to be raised across 11 banks with outstanding shortfalls, although it is fair to say that so far reviewed banks have raised an aggregate €40Bn in 2014, most likely also driven by the pressure of the review  The aggregate capital depletion identified in the Comprehensive Assessment amounts to €263Bn — but because these are prudential rather than accounting findings, only a portion of this will be reflected in banks’ balance sheets  Banks with high capital depletion are typically from countries highly affected by the sovereign debt crisis, are small, had a low credit rating, and often face restructuring requirements due to received state aid — this highlights that, without a convincing and profitable business model, state aid alone is insufficient to render banks stable  Banks with positive results are typically based in strong economies, are large or part of a larger group, and have been exposed to data-driven supervision — suggesting that data quality was an important driver of findings  In general, markets were expecting larger banks to fail and the overall shortfall to be higher, raising the question of whether the exercise is perceived as sufficiently stringent by investors  The Comprehensive Assessment could lead to a fallacy for those banks that are sufficiently capitalized but have an intrinsically weak(er) business model to lose momentum for reform and improvement  Going forward, banks should adapt their business model and risk management to the changing environment of bank supervision, which is likely to be more standardized and data driven
Strategy& Confidential property 28 October 2014 1

Overview of the European Central Bank’s (ECB’s) Comprehensive Assessment (CA)
150 Banks in 25 Countries
Asset Quality Review (AQR) and stress test Stress test only Not in scope of CA

Description of assessment
    To enhance banking transparency To restore confidence in European banks To repair banks and increase capital To prepare for the ECB’s new supervisory role which begins November 2014

Objectives

Scope

 130 participated in the full assessment, including the Asset Quality Review (AQR)  Additional 20 banks participated in the European Banking Authority (EBA) stress test  Portfolios were selected based on contribution to risk  The AQR in particular was a very extensive review involving many resources at the national competent authorities (NCAs) and at the reviewed banks  Total costs are estimated at ~€0.8–1.0Bn

Costs
Cyprus Malta

Source: Note on Comprehensive Assessment, October 2013, Strategy& analysis Strategy& Confidential property 28 October 2014 2

The ECB Comprehensive Assessment consisted of three components: an AQR, a stress test and the join-up
Components of Comprehensive Assessment
 Point-in-time assessment of the accuracy of the carrying value of banks’ assets as of Dec. 31, 2013 Asset Quality Review (AQR)  This review involved uniform methodology and harmonized definitions for all banks, in line with capital requirements regulations and directives (CRR/CRD IV)  Banks were required to have a minimum Common Equity Tier 1 (CET1) ratio of 8% after the AQR — compared to 4.5% under Basel III requirements  Forward-looking examination of the resilience of banks’ solvency under two hypothetical economic scenarios — a baseline and an adverse scenario Stress Test  The review incorporated bank calculations and centrally defined requirements in order to ensure sufficient conservatism in projections

 Banks were required to have a minimum CET1 ratio of 5.5% after the adverse scenario — compared to 4.5% under Basel III requirements
 Integration of the AQR results into the stress test for each bank according to calculations set by the ECB  Adjustment of risk parameters, valuation adjustment for fair value assets and implementation of DTA thresholds in the stress test

Join-up

Source: Aggregate report on the Comprehensive Assessment, AQR, stress test and Join-up Methodology, Strategy& analysis Strategy& Confidential property 28 October 2014 3

The assessment found that €263Bn had been lost in capital impact on top of a €49Bn drop since the CRD IV phase-in
Capital depletion in comprehensive assessment
Aggregated across 130 AQR banks in billion Euro
Tier1 / CET1%1 12.4% -0.6% 11.8% -0.4% -3.0% 8.4%

Comments
 The total CET1 capital impact found was €263Bn, of which €229Bn resulted from the stress test (incl. RWA effect) and €34Bn from the AQR  On average, banks remain well above the 8% AQR threshold, even after the stress test, but individual banks have fallen below  The average stress test impact is larger than the AQR for two main reasons – The AQR reflects current market value — the stress test reflects a performance under a hypothetical adverse scenario – The stress test covers the entire balance sheet, whereas the AQR covers only selected portfolios

1,044

49
-5%

995

34
-3%

229
CA impact: €263Bn

Total Capital 8% threshold

-22%

733

Tier 1 capital

CRD IV Starting phase-in CET1

AQR impact

ST impact

Final CET1

 The drop in capital from the CRD IV phase-in exceeds the AQR impact, highlighting the impact from Basel III on bank capital

1) Tier 1 refers to core tier 1 capital under CRD III, and CET1 refers to common equity tier 1 capital under CRD IV – average weighted by RWA Source: ECB/EBA disclosure templates, Strategy& analysis Strategy& Confidential property 28 October 2014 4

In total, 11 banks have failed the assessment with additional 14 “technical failures”
List of failed banks in CA
Banks that have to submit a capital-raising plan
Bank
Monte dei Paschi di Siena Banco Comercial Português Österreichischer Volksbanken Permanent tsb Banca Carige Dexia N.V. Hellenic Bank Banca Popolare di Vicenza Banca Popolare di Milano

Comments
Country
Italy Portugal Austria Ireland Italy Belgium Cyprus Italy Italy

Shortfall (€Mn)
2,107
1,168 1,168 865 855

Assets €Bn
4,246

State aid

199.1 82.0 40.6 37.2



 The direct capital implications from the CA are limited. Failed banks are required to raise an additional €7Bn or a mere 0.7% of total CET1 capital included in the exercise  Capital injections of €25Bn — equal to gross shortfall — to be distributed among 25 banks (including technical failures)  Characteristics of the failed banks: – Size: Mostly smaller banks failed. Average total assets of (technically) failed banks is €59Bn, compared with overall average of €170Bn – State aid: Of the 11 failed banks, 8 have received state aid since 2008. Of the 14 technical failures, 7 received state aid – Country: Most failed banks were located in Italy, with another 5 Italian banks in the technical failure group


   

818
339 276 682 682 34 31

1,839

37.0 222.9 6.4 45.2 49.4

Nova Ljubljanska banka
Nova Kreditna Banka Maribor

Capital to be raised Total shortfall

12.5
4.8




Slovenia
Slovenia

Technical failures

Another 14 banks have failed, but do not have to raise additional capital, due to restructuring efforts (2 banks) and sufficient capital being raised since Jan. 2014 (12 banks)

Source: State aid: European Commission approvals and internet search, ECB/EBA disclosure templates, Strategy& analysis Strategy& Confidential property 28 October 2014 5

The impact from the stress test is significantly higher than in the previous EBA stress test across most countries
Comparison of 2011 EBA stress test to CA 2014
Average relative CET1 impact including risk-weighted assets (RWA)
GR CY SI PT BE IE IT AT DE FI LU -11% FR NL MT ES HU -11% UK DK -10% SE -5% NO -8%
37%
24% 90% 79% 67% 49% 47% 45% 120% 13% 11% 5% 10% 11% 1% 2% 25% 21% 26% 18% 11% 0% 37% 36% 32% 25% 27% 25% 23% 22% 17%

Comments
 The comprehensive assessment was more severe than the previous EBA stress test – CA includes 3 years of stress, compared to only 2 years in the 2011 stress test – More severe scenarios have been used, for example: funding and sovereign shocks – Bank calculations have been centrally reviewed and challenged improving the quality of the results

26%
29% 8%

14%

 Previous outliers are now more in line with the majority of countries
Stress-test-only countries: starting position not adjusted by AQR

 The significantly higher financial impact in combination with the depth of the review, especially the inclusion of an AQR in parallel, adds to the credibility of the results

2014 stress test

2011 stress test

Note: The country averages are based on the 72 that have participated in both stress tests. The relative capital impact is estimated relative to the AQR-adjusted CET1% Source: ECB/EBA disclosure templates, Strategy& analysis Strategy& Confidential property 28 October 2014 6

On country level, three groups can be distinguished with regard to the impact of the comprehensive assessment
Comprehensive assessment impact per country
Total CET1 Capital impact
50 45 40 35 30 25 20 15 10 5 0 -5 3.2 1.4 8.0 3.7 1.2 0.1 0.2 0.1 15.2 13.0 22.5 90% 89%

Most impacted
47.2

Average
46.9 49.2

Least impacted

Average relative CET1 capital impact
100% 90% 80%

67% 52%

70% 60% 48% 45%

42%
35% 10.9

22.5

50% 40%

32%
27% 26%

18.5

26%

22%

20% 15% 15%

30%

15%

11% 0.1 1% -0.2

20% 10% 0% -10%

GR

CY

SI

PT

BE

IE

IT

AT

DE

LU

FI

NL

FR

MT

SK

LV

ES

LT

EE

Average relative CET1 impact
Source: ECB disclosure templates, Strategy& analysis Strategy& Confidential property

Total CET1 capital impact

28 October 2014

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The countries most impacted by the CA are by and large the same countries that suffered most in the financial crisis
Impact per country
Average impact on CET1% as percentage of starting CET1% CA < 25% CA 25–40% CA > 40% ST only < 25% ST only 25–40% ST only > 40% Not in CA or ST
1 #

Comments
 The countries most affected had also suffered in the financial crisis – Sovereign debt crisis countries, such as Greece, Italy, Portugal, Ireland, Cyprus, and Slovenia – Belgium, which had bailed out several banks during the financial crisis  The results of the comprehensive assessment are positive for 7 countries – Spain and France — performance in this data-driven exercise seems in line with banking supervision in the past – Smaller countries with above-average GDP growth, such as the Baltic states, Slovakia, and Malta  Countries with an average impact from the CA include Germany, Austria, the Netherlands, Finland, and Luxembourg

# of failed banks

2

1

1

1 2

9 1 1 3
Cyprus Malta

3

. Source: ECB/EBA disclosure templates, Strategy& analysis Strategy& Confidential property

 In the countries where AQRs were not conducted, banks had a lower CET1 impact, in spite of the relatively smaller impact from the AQR
28 October 2014 8

The sovereign bond price development was a good predictor of the outcome of the Comprehensive Assessment
Relation with government bond yield
Average relative CET1 impact vs. government bond yield
100% 90% 80%

Comments
 There is a positive relationship between government bond yield and CA impact — with only Spain as an outlier  Countries that spent a higher percentage of their GDP supporting banks showed higher impact in the comprehensive assessment  This relationship can be explained by two factors: – Stress test scenarios for countries with weaker economics have been more adverse – The sovereign debt crisis affected the banking sector of most of these countries, and the banks have not fully recovered from the crisis • The analysis underlines the importance of the European Banking Union’s objective: to disentangle the credit quality of banks from their sovereign bond positions

GR CY

Relative capital impact

70% 60% 50% 40% 30% 20% 10% 0%

SI PT IE IT

BE

DE LU AT FI MT NL LV ES FR LT SK

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% Size indicates % of GDP spent to support banks Bond yield1

1) Average of the government bond 10-year index yield in 2013; Li, LU, LA, MA and SL based on one ore more single bonds with 10-year maturity; CY based on single 6-year maturity bond; IE, and SI based on last 10 months of 2013; LI based on Q1 2014; MT based on last 5 months of 2013: LT based on Q2 2014 Source: Bloomberg, ECB/EBA disclosure templates, Strategy& analysis Strategy& Confidential property 28 October 2014 9

Banks subject to data-driven supervision have been affected less, highlighting the relevance of data quality
Relation with data-driven supervision
Average relative CET1 impact vs Data index1
100% 90% 80%

Comments
 The CA is a highly data-driven exercise; conservative assumptions are applied in case of poor data quality  Banks that have their data systems better prepared for such requests are expected to have lower findings

GR

CY

Relative capital impact

70% 60% 50% 40% 30% 20%

SI PT IE
Fast-growing countries

BE DE IT AT LU NL LT FR ES

 Data-driven supervisors implicitly also encourage banks to improve their data capabilities and meet more rigorous standards  Supervisors are considered data driven when they apply frequent and in-depth (off-site) data analyses (for example, driven by an internal credit register), when they can adjust the bank’s accounting numbers, or when they impose standardized reporting requirements  This implies that the CA impact reflects the banks’ data quality in addition to their 10 asset quality

FI MT LV EE

SK
10% 0% 3 4

5

6

7

8

9

Data Index1
1) Data index is based on: intensity of off-site data analyses, formal authority of supervisor, internal credit register, standardized reporting requirements Source: IMF reports on quality of banking supervision, IAS Plus Website, EBA website, ECB/EBA disclosure templates, Strategy& analysis Strategy& Confidential property 28 October 2014 10

Credit ratings are highly related to bank failure and CA impact, especially for speculative-grade banks
Relation with bank credit rating
Average relative CET1 impact vs credit rating1
Investment grade Starting CET1% 12.7% 11.0% Speculative grade 11.0%
53%

Comments
 Credit rating is correlated to relative capital impact, and also correlated to the probability of bank failure  The speculative-grade banks (those with ratings of B+ or lower) appear to follow a high-risk, high-return strategy. They had above-average ROA in 2013, 75% of them have received state aid in the past, and they have raised a total of €11Bn in 2014 — with a remaining shortfall of €2.7Bn  Whereas the average relative capital impact is comparable across the investment-grade banks, the probability of failure is higher for lower-rated banks

Relative Capital Impact

26%

28%

AAA / A+ # banks % banks failed per rating cluster 29 3%

A / BBB33 18%

BB+ / CCC 20 50%

 These bank failures are mainly driven by the stress test impact, suggesting that the rating captures a bank’s resilience in changing market circumstances

1) Fitch LT Issuer default rating. if ratings were not available for a group-subsidiary, then group rating was applied unless the group was not a bank or not located in Europe Source: Bloomberg, ECB/EBA disclosure templates, Strategy& analysis Strategy& Confidential property 28 October 2014 11

Banks that are under restructuring due to received state aid have higher findings than other banks
Relation with state aid received
Average relative CET1 impact vs. state aid
Starting CET1% 12.0%
43.4%

Comments
 Almost half (47%) of all in-scope banks had received some form of state support. This increases to 51% if group subsidiaries are not considered separate banks1  Findings are highest for banks that received state aide and are under restructuring - this highlights that, without a convincing and profitable business model, state aid alone is insufficient to render banks stable  Banks that have received state aid since 2008 and did not have – or finalized – restructuring requirements have comparable results to banks that did not receive state aid  However, these banks also have the lowest starting CET1%, suggesting that state support was not used to raise the capital buffer

11.3%

12.2%

25.3%

27.5%

Relative Capital Impact

State aid under restructuring # banks % banks failed per cluster 28 32%

State aid - no restructuring / restructuring completed 34 18%

No state aid received

68 15%

1) If banks are excluded that: I) are subsidiaries of in-scope banks, ii) are subsidiaries of non-banks, or non-European companies, then 54 out of 106 banks received state aid Note: State aid refers to banks which have received bank-specific government support since 2008, excluding general guarantee schemes set up in certain countries, Restructuring refers to banks which are currently implementing a restructuring plan approved by the European Commission Source: ECB Aggregated report on the comprehensive assessment, European Commission approvals and internet search, ECB/EBA disclosure templates, Strategy& analysis Strategy& Confidential property 28 October 2014 12

Small and medium sized banks were most affected, except for small subsidiaries of groups — which performed best
Relation with bank size
Average CET1 impact vs bank total assets
Bank Assets Starting CET1% <€35Bn €35 - €100Bn > €100Bn

Comments
 Large banks and their subsidiaries have substantially lower CA adjustments than small and medium sized banks  The AQR impact is higher for small and medium sized banks  There are three possible reasons for the relation between size and CA impact
27.2%

19.2%

11.2%
44.2%

12.6%
43.3%

11.5%

Relative Capital Impact

17.9%

– Access to capital markets may be restricted for small and medium-sized banks, especially when they are also relatively small in their home country. Most small non-subsidiary banks have ratings of BBB+ or lower – Risk management may be less developed at smaller banks due to scale advantages in building these capabilities – Large banks have scale advantages in adapting to changes in the regulatory environment

Small Subs1 # banks % banks failed in size cluster 19 0%

Small banks 22 36%

Medium banks 43 30%

Large banks 46 9%

1) Subsidiaries of larger groups Source: IMF reports on quality of banking supervision, IAS Plus Website, EBA website, Strategy& Analysis, ECB/EBA disclosure templates, Strategy& analysis Strategy& Confidential property 28 October 2014 13

Investors expected 5 additional banks to fail. The actual total net shortfall of €7Bn compares to the expected €51Bn
Failed banks compared to investor expectations
Expected fails
           Cooperative Central Bank Eurobank National Bank of Greece Monte dei Paschi di Siena Veneto Banca Banco Comercial Português Banca Popolare di Vicenza Banca Popolare di Milano Banca Popolare di Sondrio Piraeus Bank Banco Popolare              

Comments
 Markets were expecting larger banks to fail and the overall shortfall to be higher, raising the question whether the exercise is perceived as sufficiently stringent by investors  According to a survey by Goldman Sachs among investors, markets were expecting a gross shortfall in capital between €75Bn and €91Bn — excluding an assumed aggregate capital raised of €47Bn in the first 9 months of 2014. The expected net capital shortfall was between €28Bn and €51Bn1  In contrast, the gross capital shortfall identified in the CA is €25Bn, which results in a net shortfall of €7Bn after net capital raised in 2014  The banks that were expected to fail but passed the CA are substantially larger than the failed banks, suggesting that the assessment took bank size (“too big to fail”) into account
28 October 2014 14

Unexpected fails
Banca Carige Hellenic Bank Permanent tsb Bank of Cyprus Österreichischer Volksbanken AXA Bank Europe Münchener Hypothekenbank Credito Valtellinese Nova Kreditna Banka Maribor Dexia Nova Ljubljanska banka Banca Popolare dell'Emilia Rom. Liberbank Caise de refinancement de l’habitat 14 -72.3%

Expected, but passed
     HSH Nordbank Banco Popular Español Raiffeisen Zentralbank Österreich Commerzbank Alpha Bank

Legend Real failures Technical failures 5 -29.8%

# Banks Avge CET1 impact Net capital raised Net shortfall

11 -78.3%

€13.8Bn
€3.6Bn €78.7Bn

€4.7Bn
€3.2Bn €46.4Bn

€0.1Bn
€207.7Bn

Avge total assets

1) Based on a Goldman Sachs survey among 125 institutional investors in Sept. 2014. Source: Bloomberg, Banks listed as expected to fail are derived from the Goldman Sachs survey (Sept. 2014), Credit Suisse (Italian Banks) Feb. 2014, NBG securities on (Greek banks ), CEPS Acharya &Steffen Jan ’14, Nomura (2014) and newspaper coverage, ECB/EBA disclosure templates, Strategy& analysis Strategy& Confidential property

Findings for individual banks may lead to additional capital needs or affect banks’ operations in various ways
Implications for banks based on results
Sustainably profitable business model Opportunity to leverage strength  Use increased transparency to attract funds to fuel growth opportunities  Capitalize on M&A opportunities  Roll out superior organizational forms and processes to other jurisdictions Explain the results and fix issues  Develop clear storyline for the markets Negative results  Leverage key insights from interactions with the supervisor for fixing issues  Develop clear action plan to address identified shortcomings No convincing business model Continue to rethink business model  Positive results might provide time to fix underlying issues. It is important to keep the momentum  Revaluate risk-return for specific business areas, given regulatory scrutiny and capital demands Manage the damage  Practice active stakeholder management  Consider scenarios to isolate most affected loans / portfolios  Focus on client and talent retention Banks are prone to two misconceptions  Lack of repair is enforced by CA  False positive signal reduces urgency of change

Positive results

Source: Strategy& analysis
Strategy& Confidential property 28 October 2014 15

The CA has provided more transparency on the quality of the banks, but there are also some limitations
Evaluation of the Comprehensive Assessment
Benefits Limitations

   

Enhanced transparency of banks’ asset quality across the eurozone and basis for harmonization of bank supervision Establishes AQR as the basis for more consistent view of non-performing exposures and significant increase in NPE stock More credible than previous stress test with a more severe scenario and strong central quality control resulting in a significantly higher impact Enhanced insight for bank supervisors in portfolio-specific characteristics due to thorough assessment of loan classifications and provisions The exercise has unearthed a number of data quality issues; banks are incentivized to improve their data management capabilities

 

Findings do not lead to any judgment about the solidity of the underlying business models of individual banks The CA does not provide any guarantee for performance of the banking sector going forward, as some types of risks have not been stress-tested (e.g. liquidity, strategic and nonfinancial risks) Impact on bank capital was lower than expected by some market participants and only the banks that failed can be forced to increase their capital Results depend on the specific methodology chosen for the AQR, on national regulation (such as the treatment of tax credits) and by the assumptions in the stress test







Source: Strategy& analysis
Strategy& Confidential property 28 October 2014 16

Based on the CA, there are five focus areas where banks should invest to build or enhance their capabilities
Key capabilities that banks should develop
Risks / challenges Improvement levers  Integrate strategy, finance and risk more effectively  Incorporate funding and liquidity in investment decisions  Set up advanced data management and systems  Enhance loan-level and aggregated data  Include data insights in decision making processes  Create and enhance internal capabilities for managing stress-testing models and mechanics  Run testing models between official stress tests  Change underwriting culture, moving from collateral focus to cash-flow-driven analysis  Adapt policies and procedures to facilitate cultural transformation  Identify performance indicators  Include visibility assessment of performance in strategic decision making
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Integrated approach

 Poor strategic decision making due to insufficient insight in risk and finance aspects  Increased cost of poor data quality due to change in supervision approach  Increased scrutiny on bankexecuted stress test leading to strict adjustments  Supervisory focus shifting away from collateral-driven to cash-flow-driven underwriting  Higher capital required for assets or countries where data does not reflect performance
Confidential property

Data systems

Stress testing

Underwriting culture

Portfolio focus
Source: Strategy& analysis
Strategy&

About the authors

Dr. Peter Gassmann is a partner with Strategy& based in Frankfurt and Dusseldorf and the global leader of of the firm's financial-services practice. He also co-leads the firm’s global risk, finance, and regulation platform supporting clients to build holistic risk, liquidity, and capital management capabilities in view of the changing business and regulatory environment. Dr. Philipp Wackerbeck is a partner with Strategy& based in Munich and a member of the financial-services team, for which he co-leads the firm’s global risk, capital, and regulations platform. He has advised various banks, regulators, central banks, and supervisory authorities and has been leading various bank restructuring programs in Europe, the U.S., and the Middle East for many years. Jeroen Crijns is a senior associate with Strategy& based in Amsterdam and a member of the European financialservices team. He is an expert in the area of risk, capital, and regulation for the banking and insurance industry and has led the study about the results of the ECB Comprehensive Assessment. Dr. Christel Karsten is an associate with Strategy& based in Amsterdam and a member of the European financialservices team. She is an expert in the area of risk, capital, and regulation for the banking and insurance industry and has co-led the study about the results of the ECB Comprehensive Assessment.

The following people also contributed to this analysis: Julian Biegmann, Willem Giebels, Andreas van Braam, Erwin Hieltjes, Nina Straathof and Margret Venneboerger Strategy& Confidential property 28 October 2014 18

Contacts
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