25 banks fail ECB stress check on financial health

Depth of EU-wide audit on banks welcomed, though there was alarm at the news that 25 banks would not be able to withstand another economic crisis

Twenty-five eurozone banks failed stress tests designed to check their ability to endure another major economic crisis, the European Central Bank announced on Sunday.

The tests were part of the ECB's Comprehensive Assessment (CA) of the euro area's 130 largest banks, which examined the resilience of bank balance sheets to both a baseline and an adverse crisis scenario. The audit also incorporated an in-depth asset quality review (AQR).

It identified a total capital shortfall of €25 billion at 25 banks across Europe, based on data provided in December 2013. The central bank said that 12 banks have since taken steps to raise the required capital, which would better equip them in the event of another crisis, and the remaining 13 banks will have two weeks to submit plans to cover the shortfall within a nine-month timeframe.

The failures proved most concentrated in Italy, where a total of nine banks reported a shortfall, of which four still need to raise the adequate capital. Banca Monte dei Paschi was the worst-affected bank, found to have a capital hole of €2.1 billion. Three Greek banks were also found short, though one – Piraeus Bank – has since raised enough to satisfy supervisors. Meanwhile, three Cypriot banks and Ireland's Permanent TSB also failed to meet the requirements.

To pass, banks needed a Tier I capital ratio of 8%. This could fall to no more than 5.5% under the simulated adverse scenarios – which included another recession, a steep increase in borrowing costs and a house price collapse.

While the market expected failures of at least a dozen banks, surprises have still emerged. Nicolas Vernon, visiting fellow at the Peterson Institute for International Economics, looked at the EBA stress test results, which used a fully loaded Basel III measure of capital, and says that while it may be unsurprising that "HSH Nordbank failed the adverse scenario using this yardstick, a more interesting one, and surprising to me, is that DZ Bank fails both baseline and adverse scenarios". In addition, he believes the Bank of Italy will have a lot of explaining to do, given the high concentration of bank failures in the country.

Also of interest will be the results of the ECB's AQR, which identified that the book values of bank assets as of end-2013 need to be adjusted by €48 billion. An additional €136 billion was found in non-performing exposures, bringing the total troubled assets to €879 billion. The 130 banks examined accounted for €22 trillion worth of assets, representing 82% of total banking assets in the single currency area, the central bank said.

The ECB – which will become the single supervisor of the eurozone's largest banks on November 4 – has often said that the comprehensive assessment can be used as an opportunity to restore investor confidence in Europe's banking industry and revive the flow of credit to the economy.

Yet wider economic issues remain for the region, hampering any road to recovery. Analysts from Commerzbank said in a research note that the results of the AQR and stress tests are unlikely to give the economy as much boost as ECB president Mario Draghi expects. "According to our empirical analysis, the sluggishness in lending is not primarily attributable to a lack of supply, but rather to weak credit demand. The stress tests will not change this picture in the near term." They warned that a "weak economy constrains credit, not vice versa".

Still, the stress tests have proved more credible than the last set of tests carried out in 2011. Vernon says: "On the whole it seems to me that the ECB has passed its own stress test today – this exercise appears credible as of now. Of course, if new information emerges in the next few weeks that is inconsistent with today's disclosures – à la Bankia 2011 – then the ECB will have egg on its face. The definitive assessment on credibility in my view will come in Q1 2015, when the stressed banks release their end-2014 financial statements."

Commentators have also praised the depth of the assessment. Dale Stevens, head of risk at analytics institute SAS UK and Ireland, says: "It's a level of transparency we've not seen before, so I think it shows that the regulators are very serious about making these tests realistic and acceptable to the industry." He acknowledges potential problems with the model: "Given the approximations within the methodology employed, and the fact that the deflation scenario was overlooked, there remains a degree of concern about the model risk inherent in these tests."

One solution to this, he says, is for regulators and the banks themselves to carry out these tests much more regularly. "By adopting more frequent stress tests across a wider range of market and custom scenarios, bank boards can proactively manage the future health and robustness of the banks," he says.

This can be likened to the situation in the US, where the Federal Reserve now carries out stress tests every year. The central bank released the scenarios for its 2015 capital adequacy tests last week, with banks due to report results of the Comprehensive Capital Analysis and Review (CCAR) by January 5, 2015. Meanwhile, UK authorities have also been discussing the possibility of annual tests. The Bank of England is currently carrying out its own audit on the health of its banks, with results due to be published on December 16.

Banks still need to take further action, according to Colin Brereton, economic crisis response lead partner at PwC: "Although the comprehensive assessment should restore some confidence and stability to the market, we are still far from a solution to the banking crisis and the challenges facing the banking sector," he says. "The test of long-term viability is whether banks can generate sufficient returns to cover all their costs, including capital costs."

He says this will be a "long way off due to the prospect of continued weak economic conditions and low interest rates across Europe, an overhang of operating, compliance and restructuring costs, and mounting competitive threats from start-ups and non-bank challengers. The Comprehensive Assessment has bought time for some of Europe's banks to get themselves in shape."