European bank stocks have fallen to historically low multiples. The earnings outlook is uncertain and the banking environment is in flux. Tighter regulation, coordinated at the EU level, and challenging market conditions have forced banks to refine their business models and strategies – but all this has impacted their Return on Capital. European banks are now subject to systematic regular “stress tests” by regulators and the results of such stress tests are all put into the public domain. But what do these stress tests really tell investors?
The drama that followed the crisis
As everybody knows, in the fallout from the collapse of Lehman Brothers on 15 September 2008, the entire global banking system went into convulsions. In the USA and the UK direct government intervention in the financial system averted systemic banking collapse – every economist’s ultimate nightmare. Economists argue as to whether the financial crisis resulted from a shortage of bank capital (technically a solvency crisis) or a shortage of liquid funds to sustain bank activities during stressed market conditions (a liquidity crisis). In reality these two concepts are intimately related.
Then, by early 2010, it became clear that European financial markets, and by extension the European banking system, were under severe stress. The most obvious manifestation of this stress was the explosion in government bond yields in the most financially vulnerable countries across Southern Europe (plus Ireland). This secondary crisis became known as the European Sovereign Debt Crisis – although that epithet downplays the danger in which the European banking system found itself. Because European banks traditionally hold large volumes of government bonds (they were, in days gone by, an easy and low-risk source of yield) the fall in bond prices directly impacted their capital bases and their liquidity positions.
The European Sovereign Debt Crisis was finally alleviated after a series of massive government bailouts (Greece, Portugal, Ireland and – in a different form – Spain and Cyprus) over 2010-13 and by a late here-comes-the-cavalry intervention by the ECB. In July 2012 Mario Draghi, the new President of the Central Bank announced his intention to do whatever it takes to save the Euro. This signalled the beginning of a pro-active monetary policy involving the provision of additional liquidity to the European banking system.
Basel III to the rescue
Behind the scenes, European banks were also convulsed over this period by a new regulatory regime. Basel III, devised by the committees of the Bank of International Settlements (BIS – often called the central bank to the central banks) was a much more comprehensive framework than Basel II in that it tightened banks’ minimum capital requirements and, for the first time, imposed minimum liquidity requirements. Liquidity risk is much more intangible and more difficult to measure than solvency risk or capital at risk (CAR); but Basel III overcomes this by requiring banks to maintain minimum balances of so-called high quality liquid assets. In addition, banks must fund their balance sheets with sufficient quantities of stable funding – that is, funding sources such as customer deposits that are not likely to dry up in stressed markets.
The Basel III provisions were incorporated into the European Union’s Capital Risk Directive IV (CRD4) which was promulgated by the European Parliament in June 2013, and came into force across the EU on 01 January 2014. Most of the provisions of CRD4 have been in turn given force in law by national parliaments across Europe. In the case of the UK there has been no specific additional primary legislation; instead the new rules have been decreed by the Financial Policy Committee (FPC) of the Prudential Regulation Authority (PRA) which is an entity with powers granted by Parliament which now resides inside the Bank of England (having been transferred from the FSA in Canary Wharf).
Just to confuse everyone further, there was a second EU directive in 2013 called the Capital Regulations Directive (CRR – often called the single rulebook) which has automatic legal effect without having to be implemented by national parliaments in each country. Once again, the impact of Brexit on bank regulation in the UK is unclear, but it is reasonable to assume that, in the medium term at least, there will be a high degree of continuity. And there is a strong belief across the City that the BoE regime of bank regulation is actually more robust than the regime that has emerged in the Eurozone.
Both the capital and liquidity requirements are effectively enforced by periodic stress tests which for banks in the Eurozone are now carried out by a body called the European Banking Authority (EBA) although central banks in each Eurozone country (which are now known as National Supervisory Authorities or NSAs) may and do carry out their own stress tests. In the UK stress tests are devised and implemented by the PRA/Bank of England and in the USA by the Federal Reserve.
Some stress tests are more equal than others
There are important methodological differences between stress tests conducted by different regulators. The EBA and Bank of England stress tests for example are based on differing approaches. The EBA test assumes that banks’ balance sheets remain static throughout the stress scenario; whereas the BoE stress test is dynamic, allowing banks to dispose of assets so long as they continue to meet the projected demand for credit from the real economy. Moreover, the EBA stress test places restrictions on banks’ flexibility to assume that they take action to cut costs and boost income in the stress scenario. The BoE stress test does not impose the same constraints. For example, it allows banks to act to reduce operating costs where these are realistic[i]. (For example, they could stop paying fat bonus cheques.)
In the same way, some stress test regimes, like that carried out by the Fed in the USA, have pass-or-fail criteria: if banks “fail” then all kinds of constraints might be imposed on them. For example, Citigroup failed the Fed stress tests in March of 2012 and was disbarred from paying dividends. In contrast, the EBA in its 2016 round of stress tests abandoned pass-or-fail criteria.
This may all sound rather dry to non-banking specialists. But the periodic stress tests and other metrics provided by central banks and supervisors is making a huge amount of what I call regulator-generated information available to investors and others. The challenge, however, is that the real purpose of the stress tests is to provide reassurance to the market rather than to quantify the probability of another systemic banking crisis.
EBA Stress Tests, July 2016
The EBA stress tests for 2016 were released on 26 July were encouraging. They considered 51 banks across 15 EU and EFTA countries, including four big UK banks. In aggregate the banks analysed account for about 70 percent of total EU bank assets. The EBA concluded that the European banking sector has bolstered its capital base in recent years leading to a starting CET1 ratio for the stress test sample of 13.2 percent at the end 2015. This was 200 basis points higher than the 2014 sample and 400 basis points higher than the 2011 sample. The hypothetical stress scenario implied that the average CET1 capital ratio would fall by 380 basis points to 9.4 percent at the end of 2018.
In respect of Deutsche Bank the July stress tests concluded that it would end 2018 with a CET1 capital ratio of 12.1 percent under the “baseline” scenario and 7.8 percent under the “adverse” scenario[ii]. This was better than the outcome of the 2014 stress tests. So that’s all right then.
Meanwhile back in Germany…
When Brits think of Germany they think of sleek, precision-engineered cars. But these days when we think of German banks we should think of car crashes. The news from Deutsche Bank (ETR:DBK) goes from bad to worse. Germany’s largest bank revealed on 15 September that America’s Department of Justice had demanded US$14 billion to settle possible claims relating to its trades in Residential Mortgage-backed Securities (RMBSs) before the Credit Crunch. Deutsche Banks’s share price swooned another eight percent. This is exactly the kind of regulatory risk event that stress tests cannot measure.
If you had bought €1,000 of Deutsche Bank stock in January 2014 you would be sitting on a position worth about €260 today. The performance of Commerzbank AG (ETR:CBK) has not been much better. Deutsche Bank is now trading at around a quarter of its net book value. (It is not alone in this respect: the market currently believes that most European banks would do us all a favour by committing suicide.) Moreover, the price of five-year credit-default swaps (a form of insurance against default) on its senior debt is significantly above that paid by Europe’s other leading banks. Data released this week by America’s Federal Deposit Insurance Corporation (FDIC) on capital-asset ratios suggested that Deutsche Bank’s was one of the riskiest of a score of big banks.
Now many people assume that the Eurozone, and its banking system, can be divided between robust, hard-working and provident Northerners and the fragile, feckless and fickle Southerners. (What I call the cultural divide between the Protestants and the Catholics – but that is another conversation[iii].) This is economically inaccurate as well as an exercise in stereotyping. The German banks stand at the centre of the intricate spider’s web of default facilities which I tried to unpack back in the spring. (Britain to be sucked into EU bailout vortex.) While it is true that the Northerners like Germany and the Netherlands are surplus-generators and the Southerners are nearly all deficit-generators, ultimately the loans extended to purchase German goods by Southern buyers find their way back to German banks’ balance sheets. True, the largest balances of non-performing loans reside in Italy and elsewhere, but German banks have significant exposures to their Italian counterparts.
The weakest link in the Eurozone chain is therefore not the Italian or Greek banks, but the German ones.
Answer the question, please…
The Eurozone banks are in bigger trouble than the EBA stress tests suggest. The health of banks and national governments are still intimately linked – and therefore the idea of a single European banking system, despite the common regulation, is illusory. And there is a huge issue here for risk analysts. By the nature of the bank-by-bank stress tests they measure the idiosyncratic risk that each individual bank might be able to ride out a period of extreme market turbulence with their capital ratios intact. But they ignore the systemic risk inherent in a market panic – that one bank might go under taking counterparties down with them.
Ultimately, they tell us the stress test methodology that the Brussels mandarins have devised is deliberately concocted to place the Eurozone banking system in the best possible light (which itself is not flattering). If this is correct, there is reason to suppose that even now with these low valuations, European banks might be overvalued.
Despite the unkind things said recently on these pages about its Governor (some of them by me), the Bank of England, under the new dispensation, seems to doing a pretty reasonable job of keeping UK banks in order. And its stress tests methodology appears to be rigorous. Perhaps this is a moment to be quietly confident in our own competence to regulate ourselves. For reasons that I shall share elsewhere, I am concerned about HSBC’s (LON:HSBA) lack of strategy (apart from cost-cutting); but then again there are fantastic domestic players like Close Brothers (LON:CBG) which continue to make money with little cause for concern.
Right now I’d go for UK banks, despite all the propaganda about pass-porting rights and whatnot.
[i] See the discussion on the Bank of England website at: http://www.bankofengland.co.uk/publications/Pages/news/2016/061.aspx
[iii] Of course the Greeks are neither Protestants nor Catholics but are Orthodox!