European bank stress tests – our expectations for Friday’s results
Investors are hoping that Friday’s results of the European bank stress tests will have the same effect as a similar US exercise last year, which acted as a catalyst to spark a rally in the markets. We have a generally positive view on the likely impact of the tests, based on available information. But there are some outstanding issues and the risk remains that the pace of the response lags investor demands for an immediate, clear-cut resolution. We set out the main points, our assessment of the proposed test and our expectations of the outcome below.
The ‘Why, what, how and who?’ of the tests
Why? - Bank liquidity is drying up, with increasing questions over solvency – which will feed through into the economy through lending. Euro inter-bank offered rates (Euribor) and the price of credit default swaps (CDS, which pay the holder in the event of default) on financials are rising.
What? - The Committee of European Banking Supervisors (CEBS) will coordinate a European Union-wide stress test exercise publishing the results on Friday 23 July. The national regulators are responsible for overseeing the tests and resolving any identified problems.
How? - Each bank will be reviewed under macroeconomic scenarios for 2010 and 2011 involving 3% less growth over the next two years than the European Commission’s current forecasts (i.e. recession) and market losses on sovereign bond holdings.
Who? - 91 banks will be covered, including mutually-owned cajas and landesbanks. This represents at least half of each nation’s banking market and, across the 27 member states, represents two-thirds of the wider European Union’s (EU) banking industry.
Testing the Test
From the information available, our assessment of the test is positive, though a number of outstanding issues remain to be clarified. The test will be wide ranging – including the opaque mutual sector in Germany and Spain (landesbanks and cajas). The macro-economic scenario assumes recession, with a net contraction in economic activity out to the end of 2011, while sovereign debt holdings will also be subject to mark-to-market accounting (though only if ‘held for sale,’ as opposed to being held to maturity). Finally, the results for individual banks will be published.
The outstanding issues
How much stress? - Much investor discussion is over whether the stress tests are ‘worst case’ or reflect a sovereign default – they are not and do not. But neither did the US bank stress tests, which are widely viewed as a success.
Transparency - Investors are looking for clarity, to the extent that they will be attempting to ‘reverse engineer’ the stress test criteria and will be suspicious of any discrepancies.
Failures and Funding - A clear description of those that ‘fail’ the stress test (including the required target for equity capital) and the procedures for underwriting additional capital need to be laid out. While this will be the responsibility of the national regulator, it is obvious that some (e.g. those of Greece and, perhaps, Spain) will need assistance themselves to raise the required funds given their own government’s funding issues. We assume that the European Financial Stability Facility (EFSF) will be utilised, but, again, this remains to be confirmed.
What we expect on Friday – ‘the three Fs’
Failures – we expect that most Greek banks will fail (on the basis of mark-downs on Greek sovereign bonds alone) and that at least one bank from Portugal, Spain, Germany and Italy will fail, plus some from the more recent EU entrants in central and eastern Europe. Landesbanks and cajas are the biggest unknowns and the likely source of any shocks, rather than the quoted banks. If no banks fail the test, then the test itself is likely to be perceived to have failed. -
Funding – we expect a new target for equity capital and a ‘road map’ for banks to meet targets by the end of the year. Additionally the EFSF should provide funds to support those countries that need to finance these capital injections.
Finance– We expect that euribor and CDS will trade back to lower levels as a key indicator that the bank stress tests have resolved liquidity concerns.
Key Risks
In addition to the outstanding issues already highlighted, our key risk is local politics – especially in relation to mutually owned cajas and landesbanks – providing road-blocks to implementation. This would again highlight the gap between the speed of the EU’s response to crisis and the demands of investors for instant, clear-cut resolutions, which can lead to market paralysis.
Impact on our investment views We believe that the tests will be positive for the economic outlook. Even if the US example suggests that lending does not rebound, refinanced banks should avoid an even sharper contraction of bank lending. This would lead to a reduced drag on global growth and less downside risk from within the euro-zone and be positive for risk assets, especially equities and corporate bonds, not just in the EU.
The euro has already rallied, boosted by the demonstration of increased political and financial commitment to EU institutions. However, our concerns over longer-term structural issues within the euro-zone remain, so we continue to forecast that the euro and local assets will underperform their global peers.
Disclaimer
Issued by Coutts & Co, which is authorised and regulated by the Financial Services Authority. Coutts & Co is registered in England No. 36695. Registered office: 440 Strand, London WC2R 0QS.
The value of investments, and the income from them, can go down as well as up, and you may not recover the amount of your original investment. Past performance should not be taken as a guide to future performance. Where an investment involves exposure to a foreign currency, changes in rates of exchange may cause the value of the investment, and the income from it, to go up or down.
The information in this document is not intended as an offer or solicitation to buy or sell securities or any other investment or banking product, nor does it constitute a personal recommendation. The information is believed to be correct but cannot be guaranteed. Any opinion or forecast constitutes our judgement as at the date of issue and is subject to change without notice. Any Coutts company, or a connected company, its clients and officers may have a position or engage in transactions in any of the securities mentioned.
The analysis contained in this document has been procured, and may have been acted upon, by Coutts & Co and connected companies for their own purposes, and the results are being made available to you on this understanding. To the extent permitted by law and without being inconsistent with any applicable regulation, neither Coutts & Co nor any connected company accepts responsibility for any direct or indirect or consequential loss suffered by you or any other person as a result of your acting, or deciding not to act, in reliance upon such analysis.
Not all products and services offered by the individual Coutts companies are available in all jurisdictions, and some products and services may be available only through particular Coutts companies.
None of the overseas Coutts companies or offices is an Authorised Person subject to the rules and regulations made under the Financial Services and Markets Act 2000 for the protection of investors and depositors, and compensation under the Financial Services Compensation Scheme will not be available in respect of business transacted with them.
