Now that the European Banking Authority (EBA) has announced its 2018 solvency test results, investors should feel less stressed about systemic risks to the banking sector. Overall, most banks fared well. But it’s still important to be highly selective when investing.
What are the tests for?
The EBA tests are designed to assess the stability of the region’s banking sector. The key aims are to evaluate the resilience of banks to adverse market developments, and to contribute to the overall assessment of systemic risk in the EU financial system. In its reports, the EBA provides a very good level of disclosure, particularly around each bank’s holdings of government bonds by country, which helps gauge the relative “inter-connectedness” of domestic banks and their sovereign. This is especially important in countries where government bond yields are rising (e.g. Italy).
Are they comprehensive?
Forty-eight large EU banks were stress tested, covering about 70% of total banking sector assets. The test results were reported in terms of the impact on Common Equity Tier 1 (CET1) capital (and leverage), on both a “transitional” and more stringent “fully-loaded” (FL) regulatory basis. At the same time, the 2018 stress tests included more standardized definitions and measurement, which provided welcome consistency and comparability across countries, as well as greater credibility to the test.
How tough are they?
The exercise was carried out on banks’ end-2017 figures, applying scenarios from end-2018 to end-2020. The “baseline” scenario was in line with various growth forecasts published by the ECB in December 2017. An “adverse” scenario stressed these baseline predictions further (and was generally tougher than the last test in 2016). In terms of the level of deviation from the EU baseline by 2020, the adverse scenario included a wide range of economic shocks, and various assumptions for long-term rates, commodity markets, exchange rates, swap rates and credit spread indices.
A key upgrade to previous tests was the adjustment for IFRS9, which came into effect in January 2018. This accounting standard requires banks to estimate losses on loans not only for a 12-month perspective, as was previously the case, but across the entire life of the loan.
What did we learn?
The most keenly watched ratios are the declines in FL CET1 under the adverse stress test scenario. For the forty-eight banks, FL CET1 declines ranged from -30bps to -770 bps, with an average of -395 bps. The tests also showed a 12.5% increase in risk-weighted assets (resulting mainly from higher credit risk in the stressed scenario). Twenty-five banks would have triggered rules limiting their shareholder payouts and staff bonuses, but even so, all forty-eight banks reported transitional capital ratios above minimum “Pillar 1” requirements.
Unsurprisingly, some weak banks such as Banco BPM of Italy and NordLB of Germany featured towards the bottom of a ranking of stressed CET1 ratios. But other Italian and German banks performed better than expected, while two UK banks—Barclays and Lloyds—surprised by appearing in the bottom five. However, the adverse scenario stress assumptions were particularly brutal for the UK in view of extra Brexit risks; we believe the upcoming Bank of England (BoE) stress tests will be a better gauge of these banks’ fortunes. That’s because the BoE will allow for improvements made during the current year, and for the potential for Additional Tier 1 (AT1) subordinated debt to convert to equity in a stress scenario.
Have our views changed?
The EBA assessment of relative capital adequacy strength appears somewhat disconnected with this year’s equity share price falls (the SX7E European bank index has dropped by 32% from the end-January peak through end-October). We believe the share price declines reflect a confluence of factors, including: rising political risks (e.g. Italy, Brexit); interest-rate concerns; central banks’ policies; late credit cycle; heightened emerging-market risks; rising awareness of cyber risks; and the potential “doom loop” from the bank-sovereign nexus in many countries.
We harbour many of these concerns. However, we believe investors can continue to find attractive opportunities in subordinated debt, particularly AT1, issued by those banks with relatively strong fundamentals and coherent business models (e.g. the more defensive stories). In our view, these securities offer both high yields* and attractive value relative to the other parts of the banks’ capital structure.
*The Bloomberg Barclays Euro Contingent Capital Index yielded 6.4% as of 31st October 2018.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time. Source: AllianceBernstein.
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