Sneak preview: European banks and the 2016 stress test
The 2016 European stress test is currently being conducted to assess how well the continent’s largest banks would hold up in adverse economic circumstances. Although the overall economy in Europe has continued to improve since the first such test was conducted in 2009, the recovery of the banking industry has been limited. Share prices of most of the continent’s banks plunged early this year, and if anything, uncertainty about the health of the financial sector is increasing. It’s difficult to predict the results precisely, but our analysis suggests that the 51 banks participating in the test will have to raise a total of up to €65 billion (US$74 billion) in new capital — significantly more than they did after the previous test, in 2014.
This estimate is derived from our analysis of what this year’s test will measure. In light of the current state of Europe’s economy and its banking sector, banking authorities have made several changes to the test’s methodology this year. The evaluation will increasingly scrutinize areas such as net interest income, which is under heavy pressure in the current interest rate environment; vulnerability to volatility and overvaluation of assets by financial markets; how banks are running their business as gauged by the newly introduced conduct risk assessment; and continued dependence on capital elements that will be phased out in the coming years under Basel III.
Banks that are looking to increase their resilience to stress — although they won’t be in time for this year’s test — are well advised to structurally improve profitability and restructure their balance sheets. This requires a fundamental assessment of their overall strategy in response to the current economic and regulatory environment, and a rethinking of their business models to prepare themselves for the long haul.
The stress test medicine
In response to the devastating effects of the 2008–09 financial crisis, the European Banking Authority (EBA), together with the European Central Bank (ECB) and several national supervisors, launched a series of stress tests, beginning in 2009, in hopes of restoring the sector to financial soundness. Subsequent tests were conducted in 2010, 2011, and 2014. The tests simulated a range of conditions the continent’s banks might face and how the banks would fare, with the overall goal of assessing which banks could sustain a minimum capital level during times of severe financial stress and which banks couldn’t. Those that failed were required to raise more equity to have higher reserves in case of another crisis.
At the same time, the European Commission and internal regulators took a variety of legislative and regulatory actions designed to enhance confidence in the financial sector, including increased capital requirements and strict risk-weighting rules designed to encourage banks to improve the quality of their assets and make them safer.
But now, more than half a decade since the first such test took place, banks all over Europe remain under a great deal of pressure. Faced with a slowing global economy and negative interest rates, many banks are struggling to produce attractive returns. As a result, the STOXX 600 index of European banks fell by more than 25 percent in the first two months of 2016.
In this year’s test, the 51 largest European banks will undergo a further assessment of their ability to withstand an adverse economic environment. The results are expected to be published early in the third quarter of 2016.
The potential impact of this particular stress test on the banks taking part will be significant. The measure of overall financial strength under the common equity tier 1 (CET1) ratio is expected to drop by 390 to 600 basis points on average, compared to a decline of 260 basis points in 2014. Altogether, banks are likely to be required to generate between €15 billion (US$17 billion) and €65 billion ($74 billion) in new capital to effectively manage the risks that the test uncovers. This corresponds to a 1 to 5 percent increase over the current capital levels.
This year’s test could require raising more capital than the €25 billion ($28 billion) raised after the 2014 test. This potential requirement of new capital is particularly great considering that 123 banks participated in the 2014 EBA stress test — more than twice as many as the number participating this year.
The impact ultimately depends on a variety of factors. These include internal factors such as the banks’ credit exposure, the value of their assets, and their compliance risk, as well as external factors such as the state of the domestic economy. Most important, this year the banking authorities have made several significant changes to the methodology that may significantly affect the results.
While the test is in progress, we offer this assessment of the current state of Europe’s banking industry, the likely impact of various factors on the results of the test, whether the regulatory measures already put in place have been effective — and whether investors are right to be concerned.
Your mileage may vary
The impact of the stress test will differ considerably by country, depending on the structure and challenges of each local market (see Exhibit 1). In general, the larger European countries are further behind in restructuring their financial sector than banks in peripheral countries that have gone through European Union (E.U.)–sponsored bailout programs and consequently had to restructure their financial sectors more intensely.
Exhibit 1: Expected stress test impact on CET1 ratio and expected capital shortfall, in € billions
Germany, in particular, has many banks with relatively low returns. In Ireland and Spain, on the other hand, banks have not been able to sufficiently strengthen their capital positions and restructure their balance sheets, and a significant proportion of their capital position still contains elements that will be phased out with the implementation of Basel III. In Italy, banks are still carrying the weight of a high proportion of nonperforming loans.
Despite these daunting shortfalls the recapitalization requirements that will be set after the upcoming stress test are not going to be as straightforward as those implemented in 2014. That’s because the EBA and the ECB have decided that although the results will feed into the annual supervisory review and evaluation process there will be no standard hurdle rate to determine recapitalization requirements. Given the general tendency by regulators and supervisors to increase capital requirements, we expect that banks will be required to at least meet the pillar 1 capital requirement net of the capital conservation buffer at the end of the stress test. The actual thresholds used by the supervisors may be higher, depending on the bank in question, and might include the pillar 2 capital requirement. For example, the 2015 Greek Comprehensive Assessment, which tested the strength of the top four banks in Greece, required a minimum ratio of 8 percent for the adverse scenario.
Let’s understand the numbers
The increase in the impact on banks is, in essence, a function of the adjustments the banking authorities have made to the test’s methodology in response to the current set of external circumstances. There will be considerable variation in the way these changes affect each of the test’s elements when it comes to measuring the bank’s overall financial strength under the CET1 ratio. Although baseline operating income might show an improvement over the 2014 test, for example, it seems likely that the test will find banks in worse shape in the areas of net interest income, market risk, tax, and other capital items including Basel III transitional adjustments (see Exhibit 2).
Exhibit 2: Expected increase or decrease on CET1 ratio, by stress test element
Overall, compared with 2014, the test’s assumptions are more conservative, the test includes several additional elements, and the methodology will be more strictly enforced. Each participating bank would be well advised to make sure its particular circumstances are taken into account, however (see “Deviations from the norm”).
Deviations from the norm
The 2016 stress test is an important guide to how risks are affecting banks’ capital position. By imposing a narrowly defined common scenario and approach on all the participating banks, the methodology offers a powerful tool for comparing how the banks will perform in the test. However, that advantage comes at the cost of providing a somewhat limited understanding of the actual risk position of individual banks.
To ensure fair and plausible stress test results, banking authorities should allow for deviations from the methodology in areas where a specific bank might be overly penalized by the prescribed approach. We have not included this element in our analysis, but it is one that has repeatedly proven to be of great importance in practice. Banks that might be adversely affected by rigid application of the current methodology should address the possibility of deviating from the methodology with their supervisor during the course of the test.
A challenging interest rate environment. The financial crisis fundamentally changed the world in which banks operate, presenting real challenges to the business models of traditional balance-sheet lenders that tend to be heavily reliant on net interest income. Given the current low interest rate environment and the resulting pressure on net interest margins, banks have been forced to rethink their business models and seek out other sources of income.
In response, in the 2016 test the EBA and the ECB are increasing their emphasis on financial stresses caused by decreases in net interest income. This element of the previous test was not very advanced, leading to varying interpretations of the methodology and limiting its impact on the results — indeed, some banks even showed an increase in their net interest income under the adverse scenario.
The EBA and the ECB have closed these loopholes for the 2016 test, enabling the test to account for net interest income more accurately and in much greater detail. We estimate that the impact to the CET1 ratio will be between 140 and 300 basis points, driven primarily by the dependence of the bank’s income on net interest income. The impact on countries whose banks showed a limited impact in the 2014 test will likely be higher this year (see Exhibit 3).
Exhibit 3: Impact of decrease in net interest income on CET1 ratio, by country
Changing economic conditions. At the same time, the macroeconomic environment has improved significantly in the past two years — and bank performance is, of course, highly sensitive to the growth of the markets served. The 2014 stress test took place during an emerging eurozone crisis, unsustainable government debt in many economies in southern Europe, and negative GDP growth rates across most European countries. Although the global economy continues to struggle with consistently low interest rates and commodity prices, a slowing Chinese economy, political unrest in the developed world, and fears of another debt bubble buildup, the stress scenario for 2016 is likely to be more positive than it was for 2014 (see Exhibit 4).
Exhibit 4: Comparison of 2016 and 2014 adverse scenarios for the European Union
Certain bank activities will nonetheless come under greater pressure in the 2016 test scenario. Commercial property prices, for example, continue to decline and will therefore receive a more severe shock than they did in the previous stress test. The increasing threat of price deflation will have an overall negative impact on debt servicing capacity, and thus will also be tested more severely in 2016 — although critics are already saying that the deflation included in the scenario is too mild. It is interesting to note that the 2016 scenario continues to assume an increase in interest rates, whereas a decrease might be more in line with current developments.
The stress scenario for 2016 is likely to be more positive than it was for 2014.
Increased balance sheets. The positive effect of the improved macroeconomic outlook on credit risk will be partially offset by the larger balance sheets of most banks. Driven by the low interest rate environment, banks’ overall exposure to corporate debt, in particular, has been increasing — a surprising outcome, given the pressure on banks from governments and regulators to shorten their balance sheets. Given that credit risk has traditionally had the greatest impact on the stress test results, this element will continue to play a large role in the overall impact on banks from this year’s results. In most countries, exposure has increased with only a slight improvement in the quality of the debt (see Exhibit 5).
Exhibit 5: Nonperforming and total credit exposure as of December 2013 and June 2015
Market risk. An additional aspect of the macroenvironment is the fact that financial markets have become more volatile and banks have suffered losses as historical barriers such as the price of oil have been breached. At the same time, today’s very low interest rates present a risk to the market values of the banks’ portfolios of available for sale and fair value securities. The market valuations of these assets will likely have a greater impact on the results of the stress test than they have in the past.
Compliance. Over the past several years, major banks in Europe and the U.S. have paid more than €200 billion ($227 billion) in penalties resulting from conduct such as Libor manipulation and noncompliance with regulations. Following the lead of other regulators and supervisors, the EBA and ECB have introduced a compliance element to the 2016 stress test. As part of the test, banks will be expected to make their own assessment of their exposure to the risk of such conduct, backed up with data on historical losses. If they cannot adequately substantiate their assessment with data, they must assume a loss of 15 percent of gross income. This fallback approach suggests that, in aggregate, banks should hold as much as €80 billion ($91 billion) in capital to cover conduct and other operational risks. This impact alone will likely be the largest driver of the difference between the 2014 and 2016 tests — although for most banks, that is probably the worst-case scenario.
Call to action
Although it may be too late for banks to improve their capital positions in hopes of lessening the impact of the upcoming test, there are a couple of actions they should take to increase resilience and to prepare themselves better in the future.
First, they must improve their profitability. Banks’ profitability remains significantly below the precrisis levels of 15 to 20 percent, and their gains in profitability since the 2014 test have been very modest. The problem is that too many banks in Europe are still chasing too few returns. For many banks, these returns are considerably lower than their reasonable cost of capital, resulting in negative economic spreads.1
Profitability, however, varies considerably from country to country. Most banks have a three-year cumulative operating profit ranging between 5 and 8 percent of CET1, with Swedish, Spanish, and Dutch banks dominating. German banks, on the other hand, are facing low average operating profits that contribute just 2.3 percent of CET1 over the three-year stress test horizon (see Exhibit 6). This raises questions about the viability of German banks’ business model. The highly fragmented German banking sector, in which many banks provide the full spectrum of services in very localized regions, seems unsustainable and yields very low returns, which in turn reduce their resilience to stress, especially as their currently solid asset quality starts to worsen.
Exhibit 6: Three-year cumulative operating profit impact as % of CET1
Second, the Basel III regulations were announced several years ago and most countries will have to meet the phase-in deadline by 2018. Yet alarmingly, some banks’ capital is still composed heavily of elements that are being phased out, such as deferred tax assets (DTAs) and investments in financial institutions. The estimated impact of the regulations varies considerably by country — Ireland and Spain stand out when measured by how their phase-in efforts will impact the upcoming stress test, primarily due to the high level of DTAs that banks in these countries continue to maintain (see Exhibit 7). Banks finding themselves in this position will need to revise their capital positions quickly, by actively raising new capital, for example, or divesting underperforming assets. With the Basel III deadline drawing near, the urgency to take action is increasing.
Exhibit 7: Basel III phase-in impact (2015–18) in % of CET1
Get the answers right
Despite the high costs of conducting the 2016 stress test, we expect it to be a valuable exercise in strengthening the European financial sector. Banks are still struggling to restructure their balance sheets and adapt their business models to the current economic environment. The results will show that there are too many poorly performing banks with limited earnings capacity to cope with the losses calculated in the stress test. The goal of the expanded 2016 stress test is to push banks to increase their resilience to a wider set of scenarios, although critics have already suggested that threats such as deflation and low or even negative interest rates are not being tested sufficiently.
Ultimately, raising additional capital will not be sufficient to address the industry’s structural issues. The results we expect from the upcoming stress test indicate once again that banks must carefully assess their current strategy in response to the current economic environment and evolve their business models accordingly to improve their return on equity and thus increase their resilience to stress. If they don’t, they will likely fare no better in the next stress test — or the next financial crisis.