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European banks are better armed against macro-economic shocks

On Friday 2 November, as expected, the European Banking Authority (EBA) published the results of the 2018 EU wide stress tests on European banks’ solvency in the event of macro-economic shocks. This was the fourth exercise of the now-biannual testing which has been carried out on European Union banks.

Despite more severe tests than in 2016, banks have demonstrated their resilience

While the 2018 stress tests did not reveal extreme vulnerability in the European banking sector, they have nevertheless highlighted some unexpected results. The EBA’s chairman, Andrea Enria, observed that the adverse scenario caused substantial losses, but that the resilience of the banking sector had been strengthened by the significant increase in capital and a gradual improvement in asset quality. The DJ Euro Stoxx Banks index, which covers the largest banks in the euro area, was broadly positive following the EBA’s publication.

Application of the adverse scenario by the banks revealed an overall capital depletion of EUR 226bn – higher than in 2016 – resulting in a negative impact of nearly -400 bps on the average CET1 capital ratio of 14% for EU banks (after taking into account the -20 bps impact of the first-time application of IFRS 9, since the baseline data set is from 31 December 2017).

Credit risk losses of EUR 358bn account for the largest contribution to capital depletion, a large proportion of which is due to exposures in the United Kingdom, Italy, France, the US, Spain and Germany. Operational and market risk contributed to losses of EUR 94bn and EUR 82bn respectively, with EUR 54bn for the sole conduct risk. However, profits taken over the period counterbalanced these losses. Note that 25 banks in the EBA’s sample were forced to trigger distribution restriction measures in the adverse scenario.

The impact on the CET1 ratio varied very widely from one bank to another, ranging from -30 bps to 770 bps. If the 2016 exercise exposed the vulnerability of banks such as Monte dei Paschi di Siena (MPS) in Italy, the 2018 tests have revealed the potential fragility of five banks:  German Nord LB, specializing in shipping finance, Italy’s Banco BPM and Lloyds, Royal Bank of Scotland and Barclays in the UK. For these British banks the consequences of a “hard” Brexit were factored into the adverse scenario, as had already been the case in the 2017 stress tests conducted locally by the Bank of England. Confounding expectations, Italian banks – with the exception of Banco BPM – performed successfully in these tests. However, these results should be put into perspective, given that the Italian long-term rates in 2018 under the adverse scenario were lower than the recent market rates. Nor did the sample include MPS this time. Finally, the six main lenders in France reported diverse results, three recording CET 1 ratios below 9% and the other three levels above 10%. In all cases, banks would be ready to withstand an economic shock.

Using results to feed the supervisory review and evaluation process (SREP)

Stress tests do not contain a defined pass/fail threshold: the results provide inputs for national supervisors to calibrate additional requirements within the Pillar 2. As the baseline economic scenario has not revealed situations where minimum pillar 1 requirements were not met, the banks should not be subject to additional Pillar II requirements (P2R) on these grounds. Although they may be subject to P2R in case of poor risk governance.

However, for euro-area banks the ECB is likely to set additional capital targets (P2G – Pillar II guidance) based on the adverse scenario, reflecting a bank’s capital ratio with respect to a threshold of 5.5%, its risk exposure and its sensitivity to the stress scenarios. The ECB also made it clear that it would very closely monitor those entities reporting CET1 ratios below 9%.

Background

The 2018 stress tests were carried out on the 48 largest European banking groups, including 33 under the direct oversight of the ECB, and covering 70% of European banking system assets. The ECB opted to extend these tests to four Greek banks, whose results were released in May 2018, and to other significant banks which it oversees directly following a methodology of its own derived from the EBA. Based on their own models, and integrating the baseline and adverse scenarios provided by the European institutions, banks had between February and May to produce and submit their data to their competent authority in accordance with the methodological guide drafted by the EBA. Over the summer, supervisors challenged data provided by banks through a process of continuous dialogue. The main assumptions of the adverse scenario suggest that the EU would face a recession leading to a 2.7% fall in GDP, an unemployment rate of 9.7%, inflation at 1.7% and a fall in residential property prices of 19.1% in the period 2018 to 2020.

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