The findings of the AQR and stress tests

Financial Article 358 by Edward Rizzo - Oct 30, 2014

The long-awaited results of the Asset Quality Review (AQR) conducted by the European Central Bank and the stress tests of the European Banking Authority were released last Sunday at noon. A total of 130 banks across Europe were subject to this two-part audit, known as the Comprehensive Assessment. The Comprehensive Assessment was carried out ahead of the ECB assuming responsibility for supervising the eurozone’s biggest lenders as from 4 November.

The analysis took place across more than 119,000 borrowers of the various credit institutions and 170,000 pieces of collateral. The aim of the Comprehensive Assessment, incorporating the combined results of the AQR and the stress tests, was to ensure that the capital buffers at the most important financial institutions across the EU member states were strong enough to eliminate the need for other bailouts funded by taxpayers as was the case with a number of banks following the 2008 international financial crisis.

The Asset Quality Review (AQR) assessed the adequacy of banks’ asset valuation, classification of non-performing exposures, collateral and provisioning, while the stress test examined the resilience of banks’ balance sheets to stress scenarios, performed in close cooperation with the European Banking Authority (EBA). In the adverse scenario of the stress test, lenders were tested on their ability to withstand a 5% contraction in GDP across the EU by 2016, declining house prices and unemployment rising to 13% from the current level of 10.1%.

To pass the AQR which analysed the asset side of a Bank’s balance sheet as at 31 December 2013, a bank required a common Tier 1 capital ratio of at least 8% of risk-weighted assets. Meanwhile, the pass mark for the adverse scenario under the stress test was a capital ratio of 5.5%.

“The results revealed that 25 banks across the EU failed the test and these had a capital shortfall of €25 billion.”

The results revealed that 25 banks across the EU failed the test and these had a capital shortfall of €25 billion. However, 12 banks have already raised €15.5 billion leaving an overall shortfall of only €9.5 billion across 13 lenders. This is well below market expectations of up to €50 billion in required capital. Those banks that still have a shortfall have two weeks to submit plans detailing how this capital deficit will be covered. The shortfalls identified in the Asset Quality Review or under the baseline stress test scenario have to be covered by the end of April 2015 while those identified under the adverse stress test scenario will need to be covered by the end of July 2015.

Italy, Europe’s fourth-largest economy, fared the worst with nine of the 21 Italian banks that were examined failing the test although five of the Italian banks have already covered their shortfalls. One of the banks that failed is Banca Monte dei Paschi di Siena, the world’s oldest bank, which needs to raise €2.1 billion of extra capital.

The other banks that failed the assessment come from Greece (3), Cyprus (3) Belgium (2), Slovenia (2) and one each from Portugal, Austria, Ireland, France, Spain and Germany.

The only German bank (out of the 24 included in the two-part audit) that failed the AQR and stress test, Muenchener Hypothekenbank, already plugged its shortfall. In total, German banks achieved an average common equity Tier 1 ratio of 12.9% in the AQR and 9.1% in the adverse scenario of the stress test. Germany’s largest bank, Deutsche Bank, achieved a ratio of 8.8% while Commerzbank, the second largest bank, obtained 8%.

The UK’s four largest banks that were subjected to the audit all passed although had the minimum capital ratio been set at 7% in line with the Basle III rules due to come into effect on 1 January 2019, both Lloyds Banking Group and Royal Bank of Scotland would have failed along with another 38 institutions.

The comprehensive assessment was also conducted on three banks licensed by the MFSA on the basis of criteria that was determined by the ECB. These were Bank of Valletta plc, HSBC Bank Malta plc and Deutsche Bank (Malta) Ltd. The comprehensive assessment identified no capital shortfalls for the three locally licensed institutions as the Tier 1 capital ratio of each of these banks remained above the 8% minimum threshold after the AQR. Similarly, the results of the stress test, under the adverse scenario and including the full impact of the AQR, show that by 2016 the Tier 1 capital ratio for each of these three banks still remained well above the 5.5% established minimum threshold. Incidentally, both Bank of Valletta plc and HSBC Bank Malta plc achieved a capital ratio of 8.9%.

The EBA had conducted stress tests on two occasions over recent years. However, the reliability of such results was brought into question following the bankruptcy of some of the banks that had passed such stress tests in prior months. Although the latest stress tests were the toughest ever, some commentators criticised the fact that banks were allowed to count certain assets in their calculation of core capital although these will need to be gradually eliminated under revised banking laws over the coming years. Bloomberg reported on Sunday that had the more stringent rules been adopted (namely the elimination of goodwill and deferred tax assets in the calculation of core capital), the number of failures would have increased to 34.

“Investors will welcome an explanation by both banks in layman’s terms of the detailed Comprehensive Assessment findings…”

Although the main prominence of the results was the resultant capital ratios under the AQR and the adverse stress test scenario, little press coverage was given to the fact that the ECB also identified €136 billion in new non-performing loans mainly stemming from the property and corporate sector. This could lead to higher loan provisioning across the EU banking industry.

The detailed tables published on the website of the ECB showing the results of the Comprehensive Assessment of each bank reveal important data which has not yet attracted press mention. In fact, while the Central Bank of Malta, BOV and HSBC issued their respective press releases and company announcements on Sunday providing the resultant capital ratios arising from the AQR and the different scenarios of the stress test, no mention was made on the extent of any new non-performing loans of BOV and HSBC discovered during the AQR. Since BOV will be issuing its September 2014 full-year financial statements tomorrow afternoon, presumably additional information in this respect will be made available to the public at large on this occasion.

Investors will welcome an explanation by both banks in layman’s terms of the detailed Comprehensive Assessment findings in order to be in a position to better assess both banking institutions since any additional provisioning required as a result of the discovery of any new non-performing loans will negatively impact profitability of both banks and ultimately dividend distributions to shareholders.

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