The European Banking Authority (EBA) recently published its 2016 EU-wide stress test draft methodology for discussion. Once again, stress tests will be applied to the eurozone’s systemic banks and potentially expanded to less significant institutions. Tests are scheduled to start in the first quarter of 2016.
Since the first steps of the integration of banking supervision for the eurozone, the ambition has been to create a standard approach applicable to all lenders, in order to promote the separation between the banking sector and the local member state governments.
Following the banking crisis in Greece, Cyprus, Portugal, Spain and Ireland, the European Central Bank (ECB) has adopted the approach of direct supervision of systemic lenders, since in the case of a default it will likely be the ECB who will be called to bail them out.
The ECB aims to protect the objectivity of the findings by using a fixed standard methodology in re-auditing and stress testing the banks, however, they have ignored the fact that a ‘one size fits all’ approach creates inefficiencies in the application of the methodology, and in fact increases the risk of unreliable results.
The stress test (ST) is not only being created to determine the capital adequacy of banks but also to assess their ability to raise financing at a reasonable cost, in a very competitive capital market.
Even though the integration of banking supervision was necessary for the smooth operation of the banking sector, such shortcomings distort its competitive landscape based on the bank’s location. As a result they could inadvertently be fostering unfair competition between member states depending on whether or not a member state benefits from the application of the common methodology.
In the case of Malta, such shortcomings could potentially reduce the attractiveness of the banking sector to both local and international investors.
In the meantime, the single supervisory mechanism (SSM) of the European Central Bank is expanding its asset quality reviews (AQRs) of systemic and non-systemic banks in the single currency bloc, while also expanding its authority outside of the bloc to countries like Bulgaria, which will perform a country-wide AQR and stress test in 2016.
In Malta, such expansion will also include the less significant institutions. An exact timeline for this is not yet defined. The smaller lenders will have an even bigger challenge – that of accommodating the inefficiencies of the methodology, given their size, cost of supportive professional advisory services and access to debt and capital markets.
Both the AQR and ST methodologies have been developed by supranational regulators as an EU region-wide standardised test for all systemic banks, trying to focus on the common features of the larger banks. Although such an approach eliminates local bias, which was the primary target of the ECB/EBA, it tends to also ignore a number of both quantitative and qualitative features of local economies.
In the case of Malta, the economy has very few similarities to the economies of most countries in mainland Europe, and consequently, the banking sector serving the local economy does not really resemble that of Germany, France or Spain, where the methodology seems to be a better fit.
The stress test is not only being created to determine the capital adequacy of banks but also to assess their ability to raise financing at a reasonable cost, in a very competitive capital market
Moreover, instead of structural differences, the methodology seems to be developed so as to take into consideration a recessionary economic climate and a respective credit crunch, again not representative of a healthy economy like Malta’s, which does not seem to have been affected by the European credit and sovereign crisis.
Finally, the tests seem to fail to capture behavioural aspects of banking culture, often enough leading to misinterpretation of findings.
More specifically, there are in fact three functional areas in the context of the AQR and ST methodologies that present application and interpretation challenges for the Maltese banking sector.
1. Firstly, as part of the AQR, ECB is performing a number of tests on a data loan tape as part of the so-called data integrity validation (DIV) to assess the risk of the loan portfolio and decide how big a portion of the portfolio the ECB should review.
A lot of these proxy tests have been primarily developed to discover hidden loan restructurings and reschedulings, a phenomenon observed very often in economies that experienced intense recession like Greece, Spain, Portugal and Ireland, and to some extent Italy and France.
In the case of Malta, with no experience of economic crisis, the application of such flags may reveal misleading findings. A closer look shows that such findings are misinterpreted. For example, the concept of forbearance; a reduction in interest rates is often considered a sign of loan rescheduling linked to the inability of the borrower to service the loan.
The logic is in line with the majority of economies in the EU which experience economic recession. On the contrary, Malta’s economy is growing at a very healthy rate and such a test would not identify financial distress, but most likely the ability of a borrower to negotiate the terms of the loan with the bank.
2. Secondly, again as part of the AQR, the ECB challenges the methodology a bank is using to calculate collective provisions with the so called “challenger model”. The “challenger model” is a statistical model that studies the performance of the loan book over time to assess the statistical probability of a loan defaulting, and if so the amount of that default. The limitation of the model is that it assumes a large number of loans and a large number of default observations. This is the only way for a statistical model to produce reliable results.
However, in the case of Malta, banks do not have a sufficient number of loans for the challenger model to produce meaningful results. Furthermore, banks in Malta have a very small number of defaults that follow the road of foreclosure, reflecting the positive economic climate in the country, rendering the statistical model even less applicable. The result is that the model often produces figures required for collective provisioning higher than those actually required.
3. Finally, the stress test methodology takes country risk into consideration when stressing the loan book and the cost of financing for each bank. EBA uses the widely accepted methodology of measuring country risk by comparing the yield of government bonds of each country to the bond yield issued by Germany, which is representative of what is considered a “risk-free asset”. The limitation of this approach is that it considers government bonds to be traded in the international market and therefore priced efficiently.
In the case of Malta, this spread seems to be “inflating” the country risk. The yield of the Maltese government bonds mainly represents the premium the government needs to offer to a limited pool of investors in Malta, to be able to compete with other investments. One could compare the yield of Maltese bonds to those of Spain, Portugal and Italy to establish that Maltese bonds historically offer a higher yield, despite Malta’s much stronger performance and outlook compared to its European peers, a view confirmed once again by the latest IMF report for Malta.
As the SSM moves gradually into the application of risk haircuts to sovereign bonds, such country risk simplified methodologies may have an even greater effect down the road, since the larger banks in Malta hold a substantial amount of Maltese government bonds.
This article was released by Deloitte.