BlogSpot - October 13th, 2014
A stronger banking union thanks to stress testing the banks?
The ECB and the European Banking Authority will publish the 2014 EU-wide asset quality review and stress test results on October 26, 2014. The stress test, which assesses the resilience of EU banks to a hypothetical adverse macroeconomic scenario, uses a common methodology developed by the EBA, and applies it consistently across all participating banks. For Piers Haben, the stress tests will provide valuable insight into the progress made in cleaning their balance sheets and an unmatched level of transparency into the EU banking sector.
For Alberto Gallo, at RBS, most banks will pass, with some mid-tier Portuguese, Italian, Cypriot and German names at risk of failing. The total capital shortfall to be small. Michiel Bijlsma and Sander van Veldhuizen, in a Bruegel blog entry, indeed write that between January and July 2014 euro area banks have announced equity issuance of about €38 billion, of which €28 billion has currently been issued—of which over 75% comes from banks in Greece, Spain, Italy and Portugal. In addition, banks issued about €14 billion of Additional Tier 1 (AT1) capital, or CoCos—mostly banks in Spain, France and Germany have been big issuers.
For John O’Donnell (Reuters, hat-tip EuroIntelligence), the AQR/stress tests will be severely anti-climactic—as closing down banks would prove very hard, given that governments are still relying on national banks to fund their debt. The exercise had the positive impact of providing banks with incentives to raise capital ex ante, though some comes from dubious accounting tricks, such as the revaluation of the shares of Italian banks in the Bank of Italy, or the use of future tax credits, as noted earlier. Pierluigi Bologna et al., in a VoxEU article, find that despite substantial progress in bank deleveraging in Europe, this process may be mismanaged, to the detriment of the recovery. On the positive side, equity increases played a much larger role than asset decreases in the reduction of leverage. However, as valuations increase, more should be done to dispose of bad assets.
However, the real issue, i.e., Europe's banking system weakness and inability to grow lending, will remain according to Gallo. Despite recent improvements, capital and profitability remain scarce overall. Further, capital quality will remain questionable in the periphery, given reliance on deferred tax assets (DTAs)—a point also made by George Hay, at Reuters BreakingViews. His argument is technical: the ECB relaxation of capital requirements on deferred tax credits (very large in peripheral banks) increases the banks’ exposure to governments; and, in fine, the stress tests may actually reinforce the bank-sovereign co-dependency. The IMF latest Global Financial Stability Report provides a striking description of the weakness of the euro area banking sector. EuroIntelligence quotes the proportion of banks that cannot deliver credit growth of more than 5%: 59% in the eurozone compared to under 20% in the US.
The stress test exercise may be socially undesirable if it induces a further contraction in credit to healthy firms. Biljsma and Veldhuizen argue that if banks have to recapitalize, they prefer deleveraging over issuing fresh capital because of two market failures: (1) the cost of issuing fresh capital are born by the existing shareholders due to debt overhang and (2) because issuing capital is seen as a negative signal by the market due to information asymmetry (e.g. Marinova et al. 2014).
The stress tests/AQR are a key dimension of the EU banking union. Nicolas Veron, in a Peterson Institute note, provides an extensive review of the various elements of the banking union. Veron (Bruegel) looks at a well-known limitation of Europe’s banking union and argues that Europe’s banking union is asymmetrical, due to the concentration of small banks in a few countries: the exempted banks form a minor part of most participating countries’ financial systems, but loom large in Germany, and to an extent also in Austria and Italy. It remains to be seen how this asymmetry may, or may not, lead to future political tension and/or regulatory arbitrage across European nations. Most banks in the euro area will escape direct supervision by the European Central Bank and the Single Resolution Board. The ECB’s recently published mapping identifies 3,652 banks in the euro area, of which only 120 groups (80 percent of total euro-area banking assets) are subject to its direct supervisory authority. Germany, Austria and Italy together are home to almost four-fifths of all smaller banks, and about half of the smaller banks which the ECB calls “less significant supervised entities” are in Germany.
The Growth Outlook - Redux From the IMF
The IMF, on the occasion of the Annual Meetings, provided revised estimates for the World Economic Outlook. With new downward revisions, and a 40 percent estimated risk of recession in Europe, Olivier Blanchard argued that a structural slowdown in advanced economies would affect the pace of global growth. Gavyn Davies, in the FT, provides an overview of the recent downgrades, and thinks it is forecasting business as usual.
While the tone of the IMF annual meetings was decidedly pessimistic, a number of observers have noted large past errors in the IMF forecasts (FreeExchange). As highlighted by FT Alphaville, the forecasts between 2011 and 2014 averaged 0.6 percentage points higher than the outturn—driven mostly by overpredicting BRICs growth, partly from overestimating growth in the in the Middle East.
By Xiaqing LIU
To read similar articles, please click on the tags below:
