The European Union’s toughest-ever stress test was meant to leave banks with nowhere to hide. The results show how the bloc’s capital rules got in the way.
A total of 24 lenders failed the European Banking Authority’s stress test with a capital shortfall of 24.6 billion euros ($31.2 billion). The EBA used EU rules as applicable over the three-year horizon of the test.
These give national supervisors scope to allow banks to count instruments whose eligibility as core capital will be gradually eliminated over the next four years. Had the fully phased-in EU rules been applied, the number of failures would have increased to 34, according to a calculation by Bloomberg News based on EBA results published in London yesterday.
That may be the more reliable gauge, since capital is a measure of a bank’s capacity to absorb losses, and the jury’s still out on how well instruments such as goodwill and some deferred tax assets, admitted in the definition of capital used in the stress test, could do that job.
“The smart people will be looking at the fully loaded ratio, as that’s the one that really shows how strong banks are,” said Nicolas Veron, a fellow at the Brussels-based Bruegel research group. By providing this information, “the EBA is giving the market the tools to apply pressure on banks.”
ECB Oversight
The EBA put 123 banks in 22 countries through the stress test, which was carried out by the European Central Bank and national supervisors. It provided the so-called fully loaded capital ratio for the first time. The ECB also released the results of its Comprehensive Assessment in Frankfurt yesterday as it prepares to assume oversight of euro-area banks on Nov. 4.
The EBA’s sample largely overlaps the ECB’s, though it also contains banks from outside the euro area. To pass in the EBA’s baseline three-year scenario, which followed European Commission economic forecasts, a bank’s ratio of common equity Tier 1 to risk-weighted assets had to remain above 8 percent. In the adverse scenario, which included a hypothetical recession and bond-market collapse, the pass mark was 5.5 percent.
The results are based on banks’ balance sheets at the end of 2013. To clear the stress-test thresholds, some banks made liberal use of instruments, whose admissibility as core capital will be gradually phased out under the EU’s Capital Requirements Regulation.
While on average banks’ core 2016 capital level in the stress tests was 8.5 percent, this would have dropped to 7.6 percent had a fully loaded definition of capital been used.
Core Capital
Banks that passed the stress tests, and whose core capital level would have fallen below the 5.5 percent pass mark had a fully-loaded capital definition been used, include Greece’s Alpha Bank AE (ALPHA), Bank of Ireland and Raiffeisen Zentralbank Oesterreich AG, the main shareholder of Austria’s Raiffeisen Bank International.
Bank of Ireland (BKIR)’s capital ratio plunges to 2.9 percent from 9.3 percent, while Spain’s Liberbank SA sees its ratio fall to 2.9 percent from 5.6 percent. Three German banks -- HSH Nordbank AG, DZ Bank AG and WGZ Bank AG -- that passed the stress tests, would have failed under the more stringent version of capital with ratios of 4.8 percent, 4.9 percent and 4.6 percent, respectively.
The effect of applying a fully loaded capital definition to the stress-test results varies across nations, Piers Haben, director of oversight at the EBA, said in an interview. While Sweden is “pretty much the same,” Germany and France show some differences, he said. Basel Goal “Fully loaded disclosure is important for two reasons,” Haben said.
“First, it gives a consistent metric that can be compared across the piece, and second it tells supervisors and analysts how far along the line banks are to reaching the Basel III goal.” The EU overhauled its banking laws last year, toughening the capital requirements banks must meet to operate in the bloc.
The legislation, known as the Capital Requirements Regulation, lists a range of instruments that banks will be forced to remove from their calculations of core capital in the years ahead.
These include goodwill, an intangible asset that arises when a company is acquired for a price above book value, as well as defined benefit pension fund assets and some kinds of deferred tax assets.Most of the phasing out must be completed by 2019.
Core Capital
The law, which implements global standards set by the Basel Committee on Banking Supervision known as Basel III, allows banks to count as much as 80 percent of these assets toward their capital levels in 2014, declining to 60 percent in 2015 and 40 percent in 2016, the final year covered by the stress test. By 2018, they will count for nothing.
For some deferred tax assets, the minimum phase-out is even slower -- 10 percentage points per year, meaning the deadline for them to be totally removed from core capital is 2024. The EU legislation gives supervisors the power to decide whether lenders should have to go faster or can drag the process out for as long as possible.
With national supervisors in charge of the banks throughout the test, this leads to difficulties in comparing results across countries and potentially diminishes the value of a passing grade.
‘Dubious Value’
Deferred tax assets and goodwill “are of dubious value as to their loss-absorbing capacity to say the least,” Pierre-Henri Conac, a professor of financial-markets law at the University of Luxembourg, said by e-mail.
Their inclusion in the definition of capital used in the tests “is a major concern as this can lead to a significant overestimation of the capital strength of banks, especially those who had already to be recapitalized because of losses,” he said.
Still, “this concern has to be mitigated with the fact that EBA will provide transparency on such ‘capital,’ so that the market will be able to make its own analysis on the banks’ strength,” he said. Even the fully loaded version of the capital definition contains an exemption that would give banks some limited scope, under a cap, to continue to count two instruments in regulators’ crosshairs.
This caveat would give banks some leniency when it comes to deducting from core capital a particular type of deferred tax asset, and also significant investments in other financial institutions.
The fully loaded definition, once in place across the EU, would also leave supervisors some freedom to decide how strictly banks should value sovereign debt they hold as available for sale, a point where the EBA clamped down during the stress tests.
bloomberg.com
A total of 24 lenders failed the European Banking Authority’s stress test with a capital shortfall of 24.6 billion euros ($31.2 billion). The EBA used EU rules as applicable over the three-year horizon of the test.
These give national supervisors scope to allow banks to count instruments whose eligibility as core capital will be gradually eliminated over the next four years. Had the fully phased-in EU rules been applied, the number of failures would have increased to 34, according to a calculation by Bloomberg News based on EBA results published in London yesterday.
That may be the more reliable gauge, since capital is a measure of a bank’s capacity to absorb losses, and the jury’s still out on how well instruments such as goodwill and some deferred tax assets, admitted in the definition of capital used in the stress test, could do that job.
“The smart people will be looking at the fully loaded ratio, as that’s the one that really shows how strong banks are,” said Nicolas Veron, a fellow at the Brussels-based Bruegel research group. By providing this information, “the EBA is giving the market the tools to apply pressure on banks.”
ECB Oversight
The EBA put 123 banks in 22 countries through the stress test, which was carried out by the European Central Bank and national supervisors. It provided the so-called fully loaded capital ratio for the first time. The ECB also released the results of its Comprehensive Assessment in Frankfurt yesterday as it prepares to assume oversight of euro-area banks on Nov. 4.
The EBA’s sample largely overlaps the ECB’s, though it also contains banks from outside the euro area. To pass in the EBA’s baseline three-year scenario, which followed European Commission economic forecasts, a bank’s ratio of common equity Tier 1 to risk-weighted assets had to remain above 8 percent. In the adverse scenario, which included a hypothetical recession and bond-market collapse, the pass mark was 5.5 percent.
The results are based on banks’ balance sheets at the end of 2013. To clear the stress-test thresholds, some banks made liberal use of instruments, whose admissibility as core capital will be gradually phased out under the EU’s Capital Requirements Regulation.
While on average banks’ core 2016 capital level in the stress tests was 8.5 percent, this would have dropped to 7.6 percent had a fully loaded definition of capital been used.
Core Capital
Banks that passed the stress tests, and whose core capital level would have fallen below the 5.5 percent pass mark had a fully-loaded capital definition been used, include Greece’s Alpha Bank AE (ALPHA), Bank of Ireland and Raiffeisen Zentralbank Oesterreich AG, the main shareholder of Austria’s Raiffeisen Bank International.
Bank of Ireland (BKIR)’s capital ratio plunges to 2.9 percent from 9.3 percent, while Spain’s Liberbank SA sees its ratio fall to 2.9 percent from 5.6 percent. Three German banks -- HSH Nordbank AG, DZ Bank AG and WGZ Bank AG -- that passed the stress tests, would have failed under the more stringent version of capital with ratios of 4.8 percent, 4.9 percent and 4.6 percent, respectively.
The effect of applying a fully loaded capital definition to the stress-test results varies across nations, Piers Haben, director of oversight at the EBA, said in an interview. While Sweden is “pretty much the same,” Germany and France show some differences, he said. Basel Goal “Fully loaded disclosure is important for two reasons,” Haben said.
“First, it gives a consistent metric that can be compared across the piece, and second it tells supervisors and analysts how far along the line banks are to reaching the Basel III goal.” The EU overhauled its banking laws last year, toughening the capital requirements banks must meet to operate in the bloc.
The legislation, known as the Capital Requirements Regulation, lists a range of instruments that banks will be forced to remove from their calculations of core capital in the years ahead.
These include goodwill, an intangible asset that arises when a company is acquired for a price above book value, as well as defined benefit pension fund assets and some kinds of deferred tax assets.Most of the phasing out must be completed by 2019.
Core Capital
The law, which implements global standards set by the Basel Committee on Banking Supervision known as Basel III, allows banks to count as much as 80 percent of these assets toward their capital levels in 2014, declining to 60 percent in 2015 and 40 percent in 2016, the final year covered by the stress test. By 2018, they will count for nothing.
For some deferred tax assets, the minimum phase-out is even slower -- 10 percentage points per year, meaning the deadline for them to be totally removed from core capital is 2024. The EU legislation gives supervisors the power to decide whether lenders should have to go faster or can drag the process out for as long as possible.
With national supervisors in charge of the banks throughout the test, this leads to difficulties in comparing results across countries and potentially diminishes the value of a passing grade.
‘Dubious Value’
Deferred tax assets and goodwill “are of dubious value as to their loss-absorbing capacity to say the least,” Pierre-Henri Conac, a professor of financial-markets law at the University of Luxembourg, said by e-mail.
Their inclusion in the definition of capital used in the tests “is a major concern as this can lead to a significant overestimation of the capital strength of banks, especially those who had already to be recapitalized because of losses,” he said.
Still, “this concern has to be mitigated with the fact that EBA will provide transparency on such ‘capital,’ so that the market will be able to make its own analysis on the banks’ strength,” he said. Even the fully loaded version of the capital definition contains an exemption that would give banks some limited scope, under a cap, to continue to count two instruments in regulators’ crosshairs.
This caveat would give banks some leniency when it comes to deducting from core capital a particular type of deferred tax asset, and also significant investments in other financial institutions.
The fully loaded definition, once in place across the EU, would also leave supervisors some freedom to decide how strictly banks should value sovereign debt they hold as available for sale, a point where the EBA clamped down during the stress tests.
bloomberg.com
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