European banking stress tests have an unfortunate history of being neither particularly stressful, nor particularly effective. A case in point is the stress test carried out in July 2011.

The test was carried out by reference to what was defined as an ‘adverse scenario’. Dexia was classified as the 12th safest bank, out of 91 tested. This was on the basis of its Core Tier 1 ratio which, at 10.4 per cent, compared very favourably with the 5 per cent hurdle. Less than three months later, Dexia needed a bailout.

The question then remained as it was at the outset: who are they trying to kid? All economic antidotes are laced with political expediency, but eurozone versions are positively dripping with it.

The credibility deficit generated in that sorry episode now needs to be addressed. Unfortunately, a lingering suspicion of a propensity towards goal seek testing shall remain. From a technical perspective there is always the risk that the stress test stresses the wrong things, as opposed to insufficiently stressing the right things. In the case of Dexia the stress test focused on capital adequacy – but it was a lack of liquidity which brought the bank down.

We now move on to the latest European Banking Authority (EBA) stress test, the latest details of which were published on April 29. The test, ‘designed to assess banks’ resilience to hypothetical external shocks, will identify remaining vulnerabilities in the EU banking sector and will provide a high level of transparency into EU banks’ exposures’. The stress test will follow an Asset Quality Review, currently being undertaken, in which 124 banks are participating this time round.

The stress test adopts what is referred to by the EBA as a “common methodology”. Others might refer to it as a ‘one size fits all’ methodology. Areas covered include credit and market risks, securitisation exposures and funding risks. Risks arising from the sovereign will also be looked at – particularly interesting in the context of the authorities ostensibly wishing to decouple the banks from the sovereign, yet with the ECB having acted in a manner which perpetuates the status quo of interdependency.

Once again, the scenario being tested is characterised as being “adverse” – it appears that all EBA stress tests cater for adverse scenarios, but some are presumably more adverse than others, at least in hindsight. This adverse scenario “reflects the systemic risks that are currently assessed as representing the most pertinent threats to the stability of the EU banking sector”.

These are:

1. an increase in global yields

2. a further deterioration of credit quality in countries with feeble demand (note that this is a natural byproduct of austerity drives, which Brussels is also rather keen on)

3. stalling policy reforms jeopardising confidence in the sustainability of public finance

4. the lack of necessary bank balance sheet repair to maintain affordable market funding.

As it happens, the text is littered with some rather odd phrasing, such as the reference to an “additional market tantrum in emerging markets”.

Perhaps it sounds better in the German original. They should be more concerned about the potential for tantrums from the new European Parliament members. In the case of Maltese banks, the test includes: (See table below).

Banks may decide to curtail lending to sectors which are less attractive from a capital intensity basis

Certain comments and queries arise:

The stress tests are generally not as tough as the US and UK equivalents.

One of the macro tests is for lower inflation than forecast. One of the key issues investors have to grapple with is the threat posed by outright deflation. This is one of those tests which might look inadequate in hindsight.

Some continental banks are trading at wide discounts to net asset value. The market is already saying that the assets held are not worth the book values being ascribed, perhaps to a larger extent than envisaged by the relevant stress test.

The stress tests may be subject to the law of unintended consequences. The end objective of the stress test is to plug capital gaps. Banks may decide to curtail lending to sectors which are less attractive from a capital intensity basis. For example, a 20 per cent stress test on property values might induce banks to raise the equity portion of a house purchase – a particular risk for the first- time-buyer market.

This could bring about the very thing the test aims to cater for – a falling property market. Note also that macro tests include rising unemployment – a major threat to the assumption that concentration risk in the mortgage market is acceptable given the historically low levels of delinquency.

  2014 2015 2016
Shock in long-term MGS yields, basis points 150 110 110
Equity price shock 18.2% 15.8% 18.0%
House price shock 6.3% 10.0% 10.0%

Martin Webster is head of equity research at Curmi and Partners Ltd.

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