BANKS : AGAIN UNDER STRAIN / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

July 7, 2011 8:29 pm

Banks: Again under strain

By Patrick Jenkins and Brooke Masters

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When London’s Millennium bridge opened 11 years ago, it infamously wobbled so much that it had to be shut again within a matter of days. The “blade of light”, as designer Lord Foster named it, swiftly became known as the “wobbly bridge” after a daily load of 200,000 pedestrians walking in sync caused it to bounce and swing alarmingly.


Just as engineers at the turn of the century blamed the “wrong sort of walking”, so financial regulators eight years later blamed the wrong sort of banking for a global crisis whose effects are still felt, particularly in the eurozone.

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As bridge designers have learnt, the best way to prevent disaster is to implement effective stress-testing that takes into account not just individual actions but also herd behaviour. That is just what the European Banking Authority, the European Union’s new regulator, aims to accomplish. Next week, it is set to publish the long-awaited results of an ambitious exercise to stretch the balance sheets of 91 banks in 23 countries almost to breaking point.

The results are being closely watched – not only by banks themselves but also by investors and policymakers. How many institutions will fail? How many will just squeak by the pass mark that requires them to maintain top-quality “core tier one” capital equal to 5 per cent of their assets, even after a disaster scenario? How much capital will those banks be forced to raise? The answers, and the capital and risk analysis that comes with them, could have a profound effect both on share prices and governments’ attitudes to their banks.


Among the most scrutinised information will be unprecedented disclosure of loan portfolios and holdings of sovereign debt, including maturity profiles – particularly timely given that Greece is teetering on the brink of default and that any sovereign debt restructuring could have big ramifications for the French and German banks that are the leading holders of Greek government bonds. Regulators say the exercise is vital to force banks to be honest about potential risks. “It’s about overcoming disaster myopia in some firms,” says one.


For years, banks have run their own internal tests that model for isolated stresses: how the investment portfolio would withstand a 40 per cent slump in share prices, say; or what a 2 per cent rise in unemployment would do to the likelihood of homebuyers defaulting on their mortgage repayments. As computer modelling improved, regulators began to use their own scenarios to evaluate soundness. But only since the financial crisis has stress-testing become a vital part of the regulatory arsenal.


Attempts by increasingly sophisticated tests to model the effects of simultaneous, interdependent changes reflect the big lesson of the financial crisis – that systemic risk resulting from the interconnectedness of an increasingly complex financial sector can be economically disastrous.


As the US showed two years ago, tough transparent testing can also reassure jittery investors, particularly important with the troubles of the eurozone’s peripheral nations continuing to dominate the news.


The EBA’s aims are twofold: first, to strengthen the system by pushing banks that are thinly capitalised relative to their underlying risks into raising fresh equity: and second, to convince the world about that strength – helping investors, particularly from outside Europe, to differentiate among eurozone banks and stop shunning them en masse.


Both counts should address a persistent issue for eurozone banks, particularly those on the periphery: scant access to short-term funding. Even relatively healthy Spanish banks, for example, have abandoned financing plans in the US because of nervousness in money markets there. In Asia, too, worries are heightened. “The concern will always be the potential knock-on effect on other global regions [of] a spiralling downwards of the European economy,” says Abdul Wahid Omar, chief executive of Maybank, Malaysia’s biggest bank.


Few are convinced that the EBA can dispel such fears. Last year’s debut test in Europe, administered by the Committee of European Banking Supervisors, the EBA’s more flimsy predecessor, was discredited within months of completion. It gave a clean bill of health to all but seven of the 91 banks tested, identifying an aggregate capital shortfall of only €3.5bn ($4.7bn), way below the €30bn-€40bn estimates touted by bank analysts.


The results buoyed market sentiment initially. But by year-end Irish banks that passed had to be rescued as part of a massive EU and International Monetary Fund bail-out. As the bridge engineers might say, it was the “wrong sort of testing”.


This year’s test has also raised concern. At first, it seemed it would make similar mistakes to its predecessor. When the scenarios emerged in March, several were actually more benign than a year ago – including a 15 per cent equity markets fall, rather than the 20 per cent used in 2010, and a more benign economic environment.


The timing is ominous, too. With Greece at risk of sovereign default, any test result that underplays that likelihood will be dismissed by the markets as puff. “If there is even a selective default [of certain Greek bonds], the test result could end up looking horribly like the Irish scenario last year,” admits one European government adviser.

Overlooked effect


The more negative benchmarks set for Europe’s bank stress tests show regulators have learnt a lesson from an effect they overlooked last time.


In the 2010 tests, policymakers assumed retail banks’ underlying earnings would fall only by about 5 per cent in a bad scenario, says Huw van Steenis at Morgan Stanley. But many southern European groups underperformed the stressed case, “because policymakers had not considered the impact of deposit wars or the large increase in the cost of wholesale funding on margins”.
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But Andrea Enria, the former Italian central banker who chairs the EBA, has spent the past few months determined to convince anyone who will listen that the process has been robust and that the results will be credible.


The EBA will publish bank-by-bank information about the impact of the economic stresses on bad debts, profits and capital levels, with the result broken down into two categories – what the outcome was at the end of last year and what it was at the end of April, by which time many banks had acted to strengthen balance sheets ahead of the tests.
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The threat of the tests, combined with behind-the-scenes lobbying by Mr Enria among national regulators, has helped spur more than €50bn of capital-raising in the past year – doing much to head off failures. Morgan Stanley calculates that 19 of the 22 listed banks that only marginally passed last year have announced capital raisings. The exceptions are UniCredit of Italy and Austria’s Raiffeisen and Erste.


Analysts say a key metric of the tests’ credibility this time round will be whether there are substantial numbers of banks that fall short of the 5 per cent core tier one capital threshold once the stresses are applied. “If we could get 10-15 names, or maybe a bit more, that would help clear the uncertainty. This is the bare minimum that would make it credible,” says Daniel Davies, European banks analyst at Credit Suisse.


There is a general belief that a clutch of unlisted banks – some cajas, or savings banks, in Spain; and some of Germany’s state-owned regional Landesbanken – will fail, along with some Greek banks. The fate of the Irish and Portuguese banks, beneficiaries of state bail-outs, and of some of the mid-sized Italian lenders is also in question, analysts say.


A few months ago, however, hopes of a credible outcome looked slim. In April, when the first round of results began trickling in to the EBA’s modest headquarters in a London skyscraper, Mr Enria’s heart sank. With the process of testing delegated to national regulators and then in turn to the banks themselves, he had clearly left them too much scope to make optimistic assumptions and exploit loopholes.


Crucially, most had assumed there was no possibility that Greece would default. The EBA decided it had to come down hard to retain credibility. It sent out new guidance in June requiring all the banks to run their data again to address what Mr Enria has tactfully referred to in public as “inconsistencies and excessive optimism”.


The letter made clear that strategic changes other than capital raising made after December 31 2010 could not be used to sweeten the results. The EBA also warned banks to rethink the impact of a sudden rise in interest rates – many had assumed they would benefit from bigger lending margins, rather than suffer as a result of market turmoil.
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It was on sovereign debt, however, that the EBA’s letter announced its most significant change. Banks were told to assume specified potential downgrades in sovereign credit ratings, spelling out, for example, that debt rated triple C – the lowest possible before default, and the rating now applied to Greece – had a 36 per cent chance of defaulting and that they should model for losses of 40 per cent if that happened.


The clampdown was Mr Enria’s way of addressing the biggest criticism of the tests – that political concerns in EU institutions meant the EBA could not be seen to countenance a default of a eurozone sovereign borrower such as Greece, despite the growing possibility of just such an event.
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By insisting on the rating agency methodology, the EBA was able to maintain that it was not breaching the taboo against imposing a formal “haircut” – or enforced loss – on the value of Greek sovereign bonds. But the tactic essentially had the same effect – to the dismay of Greek banks, several of which now look more likely to fail. Markets, on the contrary, are heartened by this more stringent approach.


The challenge now is to force capital raisings on banks that fail or come close to doing so. European governments have already pledged that by the time of publication next week they will have concrete state-backed mechanisms in place to forcibly recapitalise banks within six months. That is another vast improvement on 2010, when the test’s limited bark came with no bite at all.


“What we need is what ended up doing the job [of boosting market confidence] in the US,” says Mr Davies of Credit Suisse. “There the stress tests created a long list of institutions with capital requirements in an environment where there was clear government backing for them to go out and raise the capital. Then we could clear this overhang of uncertainty that is killing the bank funding market.”


Among banks in peripheral parts of Europe, there is less optimism that this hard-charging approach is the right one. “We’re making a stress test in a very stressed environment,” says one southern European bank’s finance director. “That is not very helpful.”


Whatever the short-term effects, though, few would disagree that in the long term, stress-testing the banks – just like the two-year process of fitting anti-wobble dampers to the Millennium bridge – should make the financial system more robust. At the time, it seemed like the last roll of the dice before nationalisation beckoned for wounded giants such as Citigroup, writes Tom Braithwaite. But stress tests carried out on US banks in 2009 are now seen as the watershed moment for confidence in the financial system that Europe has so blatantly lacked.

That February, Tim Geithner, Treasury secretary, pledged a robust examination of banks’ balance sheets and additional capital infusions for the shakiest. He presented the plan as “comprehensive and forceful”. It would “clean up and strengthen the nation’s banks, bring in private capital to restart lending”. Stocks sank on what was seen as a lack of detail.


As the economy worsened, analysts began to think that even the Federal Reserve’s grim scenario for the tests – including, noted Ben Bernanke, Fed chairman, loan loss rates worse than the two years after the Great Depression – could be too rosy.


But the results were praised when they were published in May 2009 as thorough and transparent. The 19 banks that were examined had a detailed report card published and they were ordered to add a total of $74.6bn in equity to bolster their capital positions.


US officials had held a tough internal debate on how severe the stress scenarios should be and how much of the results should be made public. Some of the outcome was more luck than judgment, some acknowledge. But there was also a great deal of on-the-ground work, with supervisors scouring the loan portfolios, challenging bank executives on their numbers.


Where officials were sceptical about the ability of a management, they factored that into their assessment of how they would ride out a worsening economic storm. On the other hand, those that had particularly strong loan recovery teams were credited.


Since the 2009 results, stress testing has continued in the US, part of a new pseudo-science of “macroprudential” regulation – considering institutions’ broader impact on the financial system. The Fed announced last month that the pool of banks subject to a new annual capital test would be expanded to 35. The aims have also changed. Rather than judging whether banks need extra capital, officials are now deciding whether to let them pay more in dividends or undertake share buy-backs.


Some European officials consider the approval of dividend increases to be premature. Groups including Bank of America, which had its capital plan rejected by the Fed, consider the regime too harsh.


For their part, after the trauma of the crisis, US officials are still hesitant to claim they have come up with a magic formula and are unwilling to gloat over shortcomings of previous European tests. But some officials show frustration about the European response, which has carried over into arguments as to the appropriate future capital regime.

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Copyright The Financial Times Limited 2011.