Asset Quality Review And Stress Tests Have Been Financial Health Checks

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• 15 January 2016

Extract from “Financial Cycles, Sovereigns, Bankers and Stress Tests” under publication by Palgrave-Macmillan, New York.

Prof. Dr. Dimitris N. CHORAFAS [1]

1. Black Holes in the Finances of Euroland’s Credit Institutions

On October 17, 2014, nine days prior to the release of the Asset Quality Review (AQR) findings by the European Central Bank, Martin Wolf, the economist, was interviewed on Bloomberg News by Charlie Rose. The theme was the current economic environment and its prospects. “An economic crisis is a political crisis,” Wolf said, pointing out the huge drops in the:

• World economy,

• Employment, and

• Financial system.

Since 2007, when the Great Recession began, the world economy is in doldrums. Employment, too, has descended to the abyss while the financial system has been under stress. There is no better testimony to that than a statement made by a senior analyst in Lisbon: “It’s out of question that Novo Banco (the former Bank of Santo Spirito, a Portuguese power house) can be sold for anything close to euro 4.9 billion. No Portuguese bank is worth the book value of its equity capital.” [2]

The banks’ value chain has been shattered. In 2007, just prior to the crisis, the market capitalization of European credit institutions was euro 1.75 trillion; in 2013 it had fallen to euro 1.08 billion – at 62 percent of its former level. Their net income shrank from euro 106 billion to euro 16 billion and return on equity dropped by 90 percent: from 15.1 percent to a mere 1.5 percent. [3]

Against this bleak background and the uncertainty which it represents, have been conducted the ECB’s AQR tests. These were supposed to constitute the measurements which will dictate the policies and pace of what happens to the structuring and capital of Euroland’s 130 systemically important banks. The outcome has been expected to create problems for several governments possibly leading to a full-blown banking crisis. It is therefore reasonable to expect that negative outcomes have been manicured.

Let’s start with the rules. Minimum capital thresholds to pass the AQR are at 8 percent Common Equity Tier 1 (CET1) on a transitional basis and at 5.5 percent transitional CET1 for the stress test. These criteria have been applied to Euroland’s credit institutions with financial and accounting data as of the end of 2013. The ECB also did some mild stress tests and London-based EBA even milder (on 123 banks). Separate stress tests will be conducted for British banks, with results projected for mid-December 2014.

While the AQRs were still going on, some experts expected Italy’s lenders to fare among the worst, predicting that up to a third of the 15 Italian banks undergoing the combined asset quality reviews and stress tests could fail to pass objective financial health criteria. Neither were Greek and Spanish institutions expected to do much better. Based on the test results:

• The ECB found that 25 banks from 11 countries failed the review of strength of assets on their books, and

• The European Banking Association established that 24 banks did not pass the scrutiny of its stress testing.

Italy has been the country with the most failed banks: 9 out of ECB’s 25; followed by Greece and Cyprus, each with 3 banks. The bigger holes have been in the books of: Eurobank (euro 4.5 billion), Monte dei Paschi (euro 4.2 billion), National Bank of Greece (euro 3.4 billion), and Banco Commercial Portuguese (euro 1.1 billion).

But were the stress tests realistic? Experts found it hard to decide whether the reported shortfall was enough or too little to shore up the banks that are at risk. Few accepted the official commentaries on face value. The ECB said lenders will need to adjust their valuations by euro 48 billion ($62.4 billion) taking into account the reclassification of euro 136 billion ($176.8 billion) as non-performing – while the stock of bad loans in Euroland’s banks now stands at euro 879 billion (1.14 trillion).

According to the results of a relatively mild stress scenario, Italian lenders suffered a further hit of euro 35.5 billion ($46.2 billion), followed by French banks with euro 30.8 billion ($40 billion) and German with euro 27 billion ($35 billion). But these “stress tests” did not include deflation in southern Euroland, or other extraordinary conditions. For instance: tightening measures, substantial interest rate increases, geopolitical tensions (Iraq, Syria, Russia-Ukraine), renewed heavy pressures in Greece, Italy and Spain, default and euro exit risks – neither did they consider events of 15 standard deviations.[4]

Moreover, the ECB and EBA “stress tests” did not account for the fact that while banks might become more prepared to lend now that the AQR results are out of the way, there is no increased demand for capital from the private sector of the economy. As for the officially announced shortfall, it is unclear which banks will qualify for emergency liquidity assistance (ELA). The precedence which could be used, up to a point, is that of Cyprus Popular (Laiki) bank. It dates back to 2013 and it has been at the origin of bail-ins.

2. Getting the Bail-In Fever

A basic principle in the capital market is that in a case of bankruptcy equity is the first to fall and uninsured deposits rank junior to insured deposits. Example of the latter is Euroland’s euro 100,000 ($130’000) deposit insurance which is senior to unsecured claims and shall be exempt from bail-in (Though this notion was briefly challenged when, in early 2013, the massive bankruptcy of Cyprus banks created a whirlwind in the local capital market).

At the eye of the storm that led to bail-in policies were the short-term loans of the Popular Bank of Cyprus which had grown to euro 9 billion ($11.7 billion) – an unsustainable level. That was roughly two thirds the size of the Cypriot economy. Sound management by the central bank of Cyprus would have suggested that an institution at the verge of failure should not be bailed out with additional loans. But the issue was political and politics are not really logical – or sound.

In addition, the value of the collateral posted at the Cyprus central bank by Laiki was inflated. According to some accounts it was overstated by euro 1.3 billion ($1.7 billion). The ECB was reportedly quite concerned by the aggressive way this collateral was valued. Still, its governing council decided to go ahead with the loan, though an independent asset evaluation report by Pimco suggested that Laiki needed about euro 10 billion ($13 billion) in fresh cash. At the time that was 1,000 percent its capital base.

Analysts were left with no doubt that the Popular bank of Cyprus was finished, but by approving the loan ECB’s governing council kept it alive until an agreement could be reached with the Cyprus government. Two months later, Laiki was wound down as part of a bailout of euro 10 billion ($13 billion). The dry hole it left behind was largely covered by the huge haircut imposed on Cypriot deposit holders who ended up by losing roughly 50 percent their deposits beyond the euro 100,000 ($130,000) guaranteed by Euroland’s deposit insurance.

In violation of the principle that two wounded institutions don’t add up to a healthy one, a collapsing Laiki bank was merged into the Bank of Cyprus (which itself got into trouble in October 2014). Laiki was a relatively small bank by international standards, but a big one for Cyprus and the wrong policy of “too big to fail” has repeated itself with insane frequency.

According to some opinions the aforementioned October 2014 test failures will probably heighten a trend for takeovers. This has not been a goal of the ECB quality reviews and assets tests, but it may well be the unwanted result. Officially credit institutions that failed the AQR are given 6 months to cover their capital shortfall, while those failing the stress scenario have been allocated 9 months to do so.

Theoretically, capital shortfalls should be repaired with capital from the private sector. Practically, with the exception of a fire sale, private investors are unlikely to be interested in having good money run after bad money. The whole issue is thus reduced to the need of continuation of critical bank functions to avoid contagion. The exhaustion of assets leads to a decision about bailing-in the citizens’ fortune through confiscation, and eventually the use of public money as a backstop.

Available information suggests that the cost of the AQRs and stress tests by ECB has reached for the stars. According to semi-official accounts, it stands at euro 500 million ($650 million) or $5 million per bank. The results don’t seem to justify such a large expenditure and the fact that the ECB works by inverse delegation is not providing the best guarantees for the future. Still, it is wise to give it the benefit of the doubt and watch the deliverables of the first year of bank inspection prior to expressing a factual and documented opinion.

3. BRRD and SRM to Reward Mismanagement

In 2015, Euroland’s Bank Recovery and Resolution Directive (BRRD) and the Single Resolution Mechanism (SRM) will come into force. BRRD assigns discretion to the resolution authority to use or partially exclude certain liabilities from bail-in, if they cannot be bailed-in within a reasonable timeframe.

While the stated further out goal is to evade the destruction of value and at the same time avoid using public money, the net result is the forced requisition of private property to pay for other people’s mismanagement or plain corruption. The supervisory authorities have failed in doing their job, or simply turned a blind eye to flagrant violations of ethics. With BRRD, the European resolution authority can:

• Determine whether a bank is failing or likely to fail, and

• Impose losses on a wider population ranging from subordinated bondholders to simple depositors.

BRRD rules state that the resolution fund can provide capital or funding to a bank after 8 percent of its liabilities, or 20 percent of its risk-weighted assets (RWAs), have absorbed losses. This contrasts to the implementation of bail-in for senior unsecured debt. Until 2016, the resolution authority has the flexibility to sell the business, use the bridge bank tool, or proceed with asset separation (in conjunction with other tools). It can also employ the bail-in tool:

• To write off senior unsecured bonds,

• Or convert them into equity, which is a milder form of bail-in.

Since such measures will be applied for the first time, there is no rule book on how to go about them. A great deal will depend on the size of the capital hole and distribution of the shortfall among the 130 banks which will come under the direct supervision of the ECB. Also on whether the true numbers will be revealed and which may be the financial realities characterizing the health of the more than 5,000 Euroland banks which have not been subject to ECB’s AQR’s.

A short time prior to the official announcement of AQR results by the ECB market rumors had it that as the reviews and tests come towards conclusion capital requirements for large banks will probably continue to rise making recapitalization an even more complex financial issue.

One of the elements pointing in this direction has been a Financial Stability Board (FSB) report about the proposal for the November 2014 G20 summit for an increase in total loss absorbing capacity (TLAC) for global systemically important financial institutions. This FSB report has been suggesting that the ratio is stepped up:

• From the 16-percent to a 20-percent range, and

• To a 25 percent of risk-weighted assets.

Connected to the TLAC upgrade is the BRRD’s minimum requirements for own funds and eligible liabilities, which can be individually set by regulators. The European Banking Association is expected to draft technical regulatory standards which specify assessment criteria and a minimum requirement for own funds and eligible liabilities. The focus is on including subordinated debt and senior unsecured debt (with at least 12 months remaining on their terms) that are subject to the bail-in, as well as funds that qualify as the bank’s own funds.

Standards upgrades and more detailed capital definitions see the light in an environment of negative psychology because of increasing concerns over the health of the global economy. These continue casting a dark shadow over financial markets, keeping stock transactions volatile and driving commodities to multiyear lows.

There are indeed many reasons to be concerned about global markets. Year after year growth outlook keeps disappointing. While the Federal Reserve and Bank of England are on and off evaluating the wisdom of tightening, creditors lose confidence in the creditworthiness of several EU countries and liquidity risk remains on the radar contributing to uncertainty.

One of the challenges confronting investors is a decision whether debt issued out of holding companies is more risky than debt issued by operating companies. In principle, given that holding company debt is structurally subordinated to operating company debt it can absorb losses easier than the latter, which is a negative. Moreover, in a crisis it can be bailed-in minimizing the impact on operating entities. (The operating entity or entities could also be separated from the holding by resolution authorities.)

The aforementioned distinctions are financially important inasmuch as the bank holding company structure has long been used by US banks, and more recently by British banks, to raise capital. Britain will implement depositor ring-fencing by 2019, intended to make the ring-fenced operations:

• More resilient than under the current form, and

• Easier resolved in case the ring-fenced bank or other operations within the group, fail.

Losses could then be passed on from operating to holding firm. This will make a holding company more risky than debt issued by an operating company, because it will be structurally subordinated.

Since the holding does not have a direct claim on the cash flows or assets of a subsidiary in a liquidation case, the expected debt recovery rate could be lower for holding firm debt. For this reason rating agencies usually rate holding debt at least a notch lower than operating firm debt with comparable features, seniority, duration and currency denomination. The new variable is the results of AQRs and stress tests which may well cast a longer shadow than capital requirements alone.

[1] Copyright D.N. CHORAFAS

[2] Financial Times, October 14, 2014

[3] Credit Suisse, Global Investor, 2014

[4] Wall Street’s fall in October 1987, for example, was a 14.5 standard deviations event.

Photo by Moritz Sirowatka, Flickr, CC BY 2.0

Prof. Dr. Dimitris N. CHORAFAS

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