The much awaited EU banks stress test showed a positive progression of banks' resilience to shocks when compared to the previous test conducted in 2016. All banks passed the test, but small Italian, UK and German banks showed weakness, with the last two being a surprise. Hence, it shows that the banking sector vulnerabilities are not fully resorbed, notably regarding legacy issues from the high stock of bad loans. This is crucial as we are entering a period of slower economic growth for the few years to come. In our view, these results show that there is a need to strengthen existing tools in case of a crisis triggering a wave of bank recapitalizations. European policymakers need to make considerable progress on the precautionary tools (revamped European Stability Mechanism) and on finalizing the Banking Union. In the end, the adverse scenario tested by the EBA is not a tail risk and this means that it is key to be better prepared!
The European Banking Authority stress tested the resilience of 48 banks in 15 EU and EEA countries in an adverse scenario, which identified a set of systemic risks that may pose a threat to the financial stability of the EU banking sector. It including two consecutive years of recession in the EU of -1.2%, -2.2% and 0.7% as of 2018, 2019 and 2020 respectively, with a deviation of -8.3% from the baseline level as of end-2020. In our view, the 2019 GDP contraction considered by the EBA would be equivalent to a scenario where there is no deal on Brexit by March 2019 (25% probability) and where there is no U-turn in the Italian government fiscal expansionary policy (20% probability) which ends-up into a crisis requiring financial assistance from the European Stability Mechanism (ESM).
While the UK and the German banks surprised on the downside, results for the big Italian banks were reassuring. The four Italian banks registered a capital ratio (CET1 ratio measuring a bank’s capital against its assets) above 5.5%, a threshold that is commonly used by investors to assess if a bank passed a stress test. Out of the four banks, Banco BPM had the lowest capital ratio in the adverse scenario at 6.7%.
Why do these stress tests matter?
First they were expected to reassure investors as per the resilience of the European banks in a crisis environment notably in a context of remaining sovereign-bank nexus and a start of monetary policy normalization by the ECB in late 2019. Looking at the banking sector performance YTD, rising tensions are indeed visible: -30% since January 2018, significantly underperforming the rest of the equity market. Renewed turbulence in sovereign debt markets may then hit the weakest banking sectors – some of which still hold significant amounts of their sovereign’s debt: around 18% in Italy, 13% in Spain, 8% in Germany and 6% in France. Attention could also go towards core banks (German, French) with large subsidiaries in most vulnerable countries. Markets are currently closely watching developments in Italy where the state-bank nexus is the strongest in the Eurozone. They are getting increasingly concerned about the erosion of banks’ capital due to the rise in BTP yields. Should the Italian 10-year yield increase to 4.5% banks’ would enter a dangerous zone: a rise in +200bp rise in yields would reduce by more than -50bp the capital ratio for biggest Italian banks and more than -150bp for the smallest. The ECB Bank Lending Survey shows that Italian banks already face a significant increase of their funding costs. This will translate into higher bank interest rates on loans to the private sector. We estimate that +100bp of rise in the sovereign yields in Italy would translate into +80bp of rise in the bank interest rates for corporates 3 to 6 months later given the low profitability of Italian banks.
In addition to the state-bank nexus, solving the legacy issues from still high stock of bad loans is crucial for the banks in the Southern European countries, notably Italy.
We have argued earlier in the year in our report The Italian Economy: 2 Years to Transform, 5 Macron-Omics, 12 Actions that one solution would be to improve collateral rules on corporate loans to restore the credit channel. The IMF estimates that halving the NPL ratio from 14% to 6% would lead to +2% higher real GDP growth and +4% higher investment growth after five years.
Currently, the bulk of NPLs continues to be corporate-related (70%) and the 11.4% of total loan book in bad debt continues to be a significant drag on bank profitability and economic activity as they require significant loan-loss provisions, which in turn reduces credit availability.
Simplifying and harmonizing collateral rules on corporate loans would make NPL valuation and sales much easier and could unleash additional bank financing. Currently, corporate loans are backed by anything from factories, to machinery, to shares of a firm and real estate, which make their valuation complex compared to residential mortgages, for example.
Second, the bank stress tests results were expected to reassure EU policymakers as per the consolidation of the banking sector in Southern European countries and pave the way for progress on the Eurozone reforms currently in the pipeline.
Three main reforms are pending:
(i) the set-up of a common backstop to bank resolution, (ii) the ESM reform aiming to include precautionary instruments for countries with sound fundamentals that need financial assistance, and (iii) setting out a roadmap for political discussion on the Deposit Insurance Scheme. In our view, the banking sector’s weakness spreading to other banks than in Southern Europe only (i.e. German banks) could be a catalyst for implementing these reforms in a timely manner.
Finally, reducing the burden of non-performing loans could be faster through securitization and more efficient should the Eurozone push ahead with the Capital Market Union.
Bank landing Survey - factors contributing to banks’ credit conditions
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The View November-December 2018