Stress testing European banks

Late on Friday evening in London, the EBA will release a report and reams of data showing the results of a "stress test" of the continent's 51 biggest banks.

Initiated in February using data from banks' balance sheets as they were at the end of 2015, the stress test is a detailed assessment of how the balance sheets would hold up under two scenarios of economic conditions over the next three years:

A baseline scenario of an economy experiencing moderate economic growth, and a pessimistic scenario that assumes a slowing economy that shrinks by 1.2 percent in 2016 and 1.3 percent in 2017. The pessimistic scenario assumes a range of financial conditions harmful to banks' bottom lines, such as a sharp slump in property prices.

The scenario numbers aren't meant to be projections. They're just assumptions used as data inputs to a balance sheet assessment process meant to probe for weaknesses and vulnerabilities in each bank's portfolio of assets and liabilities.

"The point is to help EBA and the various national banking regulators decide what kinds of changes each bank needs to make to strengthen its balance sheet - for example, by selling off, at a discount, portfolios of mortgage loans that are in arrears, or by raising extra capital by investors to serve as a buffer against possible losses, or by reducing dividend payouts and retaining more earnings for the same purpose," said Miguel Carrión Álvarez, a London and Madrid based financial analyst.

That all sounds technical and dry - and it is. But the crash of 2008 showed what can happen when banks' balance sheets collapse into insolvency, so keeping them healthy - which is to say, well-capitalized, free of excessive downside risks, and resilient even in downturns - is crucial.

The stress tests are, in essence, the equivalent of a thorough medical checkup. The European Banking Authority, which was formed in 2011 as one of the responses to the 2008 crash, uses stress tests to check on the health of European bank balance sheets, not just under current conditions, but also under conditions of somewhat higher economic stress.

Balance sheet tribulations

The balance sheets of many of Europe's banks are not, in fact, very healthy. Italian banks are staggering under an estimated 360 billion euros ($400 billion) in bad loans; one of them, Monte dei Paschi di Siena (headquarters pictured at top) - the oldest bank in the world - is at the edge of insolvency, and in need of emergency recapitalisation measures.

Italy's government wants to recapitalise the country's troubled banks with public money in order to avoid private investors or depositors having to take losses, or "bail-in haircuts" - but new rules introduced in 2013 within the framework of the new European banking union agreements were specifically meant to stop the taxpayer having to bail out banks.

That dispute can't be resolved by the results of the stress-tests, but they'll provide analysts and regulators with a clearer picture of how many billions in new investment money Italian banks will need to pull in - whether from the Italian government or from private investors - in order to stay on the safe side of banking union prudential guidelines.

Investors will also be interested to see what the stress-test results reveal about two of Germany's biggest private banks - Deutsche Bank and Commerzbank - which have been struggling to put years of costly mistakes behind them, including, in the case of Deutsche Bank, self-inflicted wounds from multi-billion dollar fines imposed by regulators after a long series of illegal dealings in years not long past, such as participation in interest-rate rigging. Both institutions face painful rounds of cost-cutting.

Data, controversy, and ambiguity

The current round of stress tests has been controversial, for several reasons. In a previous round, during 2014, the EBA stress tests assigned a round of "pass" or "fail" to each bank, with a "fail" implying that the bank didn't have a sufficient capital buffer and needed to stock up on fresh investment money to cover potential losses in any downturn, or other balance-sheet risks.

Not this time. There is no pass/fail grade. Instead, investors will have to try to interpret large data sets, composed of thousands of separate numbers derived from stress-test balance-sheet assessments.

"It'll be a lot of numbers, although for each bank, there will be summaries of key ratios like the capital ratio for each of the three years, and so on. But it will be a fairly useful data set for analysts, since a spreadsheet will made available for each bank with the stress-test data in it. Analysts will be able to work with the numbers on their own," said Carrión Álvarez.

More importantly, the stress-test results will inform the negotiations between banks and their supervisory institutions - the European Central Bank's Banking Supervision division and national banking supervisors. Each bank has to go through something called a "Supervisory Review and Evaluation Process" (SREP) on a regular basis.

The supervisory institutions will use EBA's stress-test results for each bank to inform the demands it makes on that bank to improve its particular balance sheet - whether by retaining more earnings, getting underperforming loans off its balance sheet through discount loan portfolio sales, selling off high-risk bonds from its portfolio, or other portfolio measures.

Carrión Álvarez said that there appeared to have been some misunderstandings about the nature of the tests, on the part of some commentators who criticized the absence of pass-fail marks in this round of stress-tests, saying it will be difficult to interpret the reams of detailed data about each bank that will be released by the EBA on Friday evening.

"In the last major round of European banking stress tests, the objective was to prepare for recapitalisation of Europe's banks before the European banking union came into force, in order to start with a clean slate," he said. The pass-fail mark supported that. Some banks needed new money to meet regulatory requirements, others didn't.

"The new stress-test process has been designed for a different purpose," he explained. "It's meant to support the regular annual SREP process, and help supervisors use their discretionary powers to determine what each bank needs to do to ensure it has a sufficiently healthy and resilient balance sheet, even if the economy goes into recession for a couple of years."