A Tale Of Two Stress Tests

You don’t often associate an “I told you so” moment with the release of a banking stress test, but I definitely experienced one of those after reading the recent findings of the Bank of England.

Frankly, I had spent the previous few weeks scratching my head after reading the headlines following the European Banking Authority (EBA) stress test, as I was mystified as to why three of the top five biggest deteriorations in capital came from the UK banks; yet, some like the Italian banks were seen as the pillars of the establishment in the capital league tables.

The Bank of England, by contrast, has concluded that UK banks are all well-positioned (to varying degrees) with regards capital provisioning. This being the case, we will explore the reasons why the EBA test, involving the largest 48 European financial institutions covered approximately 70% of EU banking sector assets was perhaps, at best, misleading.

The EBA stress test aimed to examine the resilience of the banks’ balance sheets to a hypothetical economic crisis embodied in severe economic shocks. The hypothetical shocks saw the EU economy shrink by several hundred basis points over a two-year period, with large drops in real estate prices and decades high unemployment levels.

The results indicated that all 48 banks tested had sufficient capital to withstand the economic recession modelled by the EBA. None of the banks dipped below the 5.5% capital ratio threshold that is used by analysts as a de facto failure rate [the EBA test doesn’t have a fail/pass outcome like the Bank of England’s or the Fed’s stress tests].

Although none of the banks tested reached critical capital levels, it was surprising to find UK banks Barclays, RBS and Lloyds accounting for three out of the top five biggest deteriorations in capital over the two-year stress period. The test left Barclays and Lloyds performing worse than indebted Italian institutions and ending up among the three worst performing banks in the test [figure 1]. Barclays was the worst performer out of the 48 banks with its capital ratio reaching a mere 6.37% at the end of the stress period.

The UK was the most affected geography, both in terms of capital deterioration and final capital levels. Even Italian banks performed better in the test than British household names Lloyds and Barclays, with RBS and HSBC not too far ahead. So, why did the UK perform so badly?

The main driver of this poor performance is the economic scenario imposed on the UK relative to the other geographies tested. The economic shocks imposed on each economy were not homogenous across the 15 regions tested i.e. the testing ground is not the same for all the banks. Figures 2-4 show what the economic shocks imposed look like for four main EU economies.

By far, the UK is tested against a significantly harsher economic scenario than most other countries, with the EBA imposing severely recessionary shocks on the UK including a 3% fall in GDP in the first year alone, and a 29% drop in commercial real estate capital values.

Furthermore, the EBA test suffers from “structural” problems and limitations. For one, it only looks at a snapshot of the banks’ balance sheets and doesn’t take into consideration measures that will very likely be taken by the banks to strengthen their capital positions during an economic downturn. This shortcoming of the test was even acknowledged by the EBA’s own top watchdog Andrea Enria, who argued that elements of the test are no longer “tenable” and need a redesign.

It is for reasons such as this that neither banks nor markets see the EBA’s test as on par with other central bank tests, namely the BoE and the Fed. The merit of not taking the EBA’s test too seriously has now been shown by the truer test of the resilience and strength of the UK banking system, as revealed in the results of the Bank of England’s test.

In the meantime, perhaps we should leave the last word to the bond markets, who were not fooled by the EBA results; looking at corporate bond spreads, the market seems to have consistently been of the view that UK banks are far safer and more sustainable institutions than their Italian counter parts, as opposed to the test’s findings.

Bonds selected for spreads:

By Richard Dakin, Managing Director, EMEA, Capital Advisors, CBRE.