25 Banks Failed, Sort of …

We noted on the eve of the publication of the ECB’s “comprehensive assessment” of European banks (here is the ECB’s complete report, pdf) that the central bank’s review would likely be more stringent than the EBA’s stress tests during the euro area crisis, because the central bank will become their supervisor.

However, it would also not be too harsh in its assessments, as it probably wants to avoid unnerving the markets. Apparently, this is precisely what happened. For instance, the WSJ informs us that “ECB Says Most Banks Are Healthy”. 25 banks failed the test technically, but only 13 of them actually need to come up with additional capital. A similar feelgood article appeared at Reuters, entitled “ECB fails 25 banks in health check but problems largely solved”. The WSJ writes:

“Hoping to quell years of anxiety about Europe’s financial health, regulators said Sunday that all but 13 of the continent’s leading banks have enough capital to ride out another economic storm.

The European Central Bank and the European Banking Authority announced the results of a nearly yearlong effort to assess the finances of 150 banks, identifying 13 that still need to come up with a total of €9.5 billion ($12 billion) in extra capital. Overall, 25 banks technically failed the so-called stress tests, facing a cumulative shortfall of €24.6 billion. But most have already taken steps to solve their problems since the end of 2013, the cutoff date for the exercise.

To pass the tests, banks had to show that they had ample capital to survive a crisis that would cause Europe’s economy to fall 7% below current forecasts and the unemployment rate to rise to 13%.

The exams are part of an effort to reassure investors and the public that, following years of destabilizing banking meltdowns and long after the U.S. defused its financial crisis, Europe’s lenders are back on solid footing. Restoring that confidence is a top priority, because the continent’s sluggish economy needs healthy banks to provide loans to households and businesses.

For the ECB, Sunday’s results are the final milestone before it takes over supervision of major eurozone banks on Nov. 4. Turning the ECB into the currency union’s bank watchdog is a key step to setting up a so-called eurozone banking union. The hope is that moving control over important banks out of national hands will prevent the kind of banking crises that rocked Ireland, Spain and Cyprus in recent years.

Investors and analysts mostly applauded the tests, saying they appeared to be much more rigorous than previous years’ versions. But some expressed disappointment that European Union supervisors didn’t take the opportunity to get more banks to thicken their capital cushions.

Philippe Bodereau, global head of financial research at Pimco, said the regulators’ strictures were a step in the right direction. But “I would have preferred they be a bit tougher and force more [banks] to raise capital,” he said.

So other observers have come to the same conclusion that we have come to before the publication already: the test was better than its predecessors, but still not really good enough. In our opinion the term “hope” is employed far too often in this context. Hope is not a financial strategy.

European stress tests compared: the difference to 2011 seems marginal

Getting Better and Worse at the Same Time

Looking a bit more closely, the numbers still look quite stunning. As we have pointed out on Friday (see: “Stress Test Angst” for details), it is certainly true that European banks have increased their tier-1 capital. At the same time however, non-performing loans (NPLs) on the books of banks in several peripheral crisis countries have continued to rise. Moreover, one of the assets that banks have piled into have been government bonds, since those have a risk weighting of zero. This carry trade has presumably helped them greatly, as bond yields have declined sharply since Mario Draghi’s OMT promise. Now that yields are at rock-bottom, it seems however especially bizarre to think of these bonds as “risk free”.

The ECB’s exercise discovered the following small errors in bank balance sheets:

“In contrast to previous stress tests, the ECB this time around also reviewed the quality of bank assets, such as mortgages, corporate loans and other investments, to determine whether they were accurately valued. That process resulted in banks being forced to reduce the value of their assets by a total of €47.5 billion, the ECB said. The central bank also identified an extra €135.9 billion of troubled assets, known as nonperforming exposures, sitting on the balance sheets of the eurozone banks.”

Curiously, the WSJ doesn’t mention what this means in terms of total NPLs in the euro area. They now amount to € 879 billion (approx. $1.1 trn.). Of these, about € 90 billion can be found in tiny Greece alone. And yet, Greek banks only need to lower their asset values by € 7.6 bn., or 4% of their risk-weighted assets and their total capital shortfall “after taking restructuring actions since the stress test into account” is basically zero.Three of the four big Greek banks failed the test and concurrently didn’t fail it (since there are no further demands to strengthen their capital on an aggregated basis).

Not one of the articles in the press mentions what aggregate loan loss provisions in the euro area are amount to at present. This is also not mentioned in the ECB’s comprehensive assessment. Given recovery assumptions, these provisions don’t need to cover anything near the total amount of NPLs, but we suspect that they are really quite small compared to current NPL figures. Although we don’t know the precise amounts at this time, we know that in the course of the “recovery”, banks everywhere in Europe have lowered their loan loss provisions. Banks are forced to walk a fine line with regards to such provisions, as regulators don’t want them to be used as “cookie jars” – however, they do tend to paint earnings prettier when they are reduced, and the question whether they are really adequate remains.

Moreover, euro area banks are profitability-challenged, to put it mildly. Their large one-off trading gains in sovereign bonds and other high grade bonds and their low funding costs cannot outweigh the continuing onslaught of write-offs, rising regulatory costs and most importantly, deteriorating net interest margins.

Lastly, there is also some questionable accounting going on at banks in the periphery, specifically with respect to deferred tax assets. As Bloomberg reported in September:

“Portugal last month joined Italy and Spain in permitting the conversion of some deferred tax assets into credits that banks can count toward the capital they’re required to have on hand. When a company overpays taxes in one period, it can book a deferred tax asset that reduces its liability in the future. Greece is considering a similar move. All but Italy received bailouts during the debt crisis that included aid for banks.

The rule changes are a boon to banks as they try to satisfy tougher post-crisis capital requirements and pass this year’s health check conducted by the European Central Bank and the European Banking Authority. At the same time, the credits give banks a claim on the public purse, strengthening the vicious circle that fueled the euro-area crisis.

[...]

These assets accounted for about 10 percent, or 105 billion euros ($138 billion), of the core Tier 1 capital of banks assessed in a July 2011 stress tests, though some lenders’ levels are far higher, according to EBA data.

The deferred tax assets in regulators’ crosshairs are those that banks can only make use of when they are profitable. Since profitability is never guaranteed, regulators stipulated that they aren’t reliable enough to count toward more than 10 percent of a bank’s core capital requirements. These rules laid down by the Basel Committee on Banking Supervision and the EU come gradually into force in the next five years.

In Portugal, the government permitted companies to convert deferred tax assets into tax credits when they report losses. To qualify for this option, companies must issue conversion rights that will give the state the right to become a shareholder or sell those rights in the market, Finance Minister Maria Luis Albuquerque said in June.

Spain passed rules last year that allowed the country’s banks to keep counting 30 billion euros of deferred tax assets as capital under the latest international rules, known as Basel III. The large amount held by Spain’s banks mostly stems from losses booked in 2012 as the government forced them to clean up their real estate assets.”

So Spain’s banks alone have € 30 billion in make-believe capital, the existence of which depends on both their future profitability and the government’s solvency. Note here that even after the precipitous price declines of recent years, Spain’s housing market remains overvalued. As Exane BNP’s excellent Spanish bank analyst Santiago López Díaz noted earlier this year in this context:

“House prices declined by 0.5% in Q1 14, making it the 24th consecutive quarter in which nationwide house prices have declined. The y/y rate of decline in house prices at the end of March 2014 was 3.8%. Official house prices have fallen 31% from the peak reached at the beginning of 2008 and stand at 2004 levels (in real terms prices have declined by close to 41% from the peak).

But the market is still overvalued…

After-tax affordability (payments/income) has deteriorated from 26.7% at the end of 2012 to 33.2% at the end of 2013 due to the elimination of tax breaks for home purchases, the increase in personal income taxes, the reduction of disposable income and the significant increase in new mortgage spreads. Counterintuitive as this might seem, buying a house in Spain is now as expensive as in 2007 and 17% above the long term average. Home sales in Q1 2014 declined by 14% y/y and the number of newly-mortgaged properties has declined for the eighth consecutive year with an impressive 32% y/y decline at the end of February (85% down from the peak).”

Not surprisingly, Spain’s NPLs continue to hit new highs (even though they are a lagging indicator of the economy and their growth has slowed down, their sheer size is astonishing, especially considering that SAREB – Spain’s official “bad bank” – has taken over a fair chunk of them). In August (latest available data), the NPL ratio was at a record high 13.24%, with total loans outstanding at € 1.39 trillion ($1.78 trillion) and bad loans at € 184.31 billion.

This chart is slightly dated, but Spain’s NPL percentage has just hit a new high – click to enlarge.

Most of the banks with capital shortfalls were identified in Italy, where also the only bank has its domicile for which the result quite possibly means the end of the road: Monte dei Paschi di Siena, which lost about one third of its stated capital as a result of the ECB’s asset revaluation. Its stock opened down almost 20% in Italy this morning, and trading was immediately suspended:

Monte dei Paschi di Siena: in the days before the stress test publication, hope crept back into the share price. This morning the stock opened down almost 20% and trading was suspended. The last quoted price we have seen was actually slightly below 80 cents (as opposed to the price indicated on the chart) – click to enlarge.

Conclusion:

Given the still, or depending on one’s perspective, once again, decrepit state of Europe’s economy, a realstress test may well be on its way. In that case, it will soon become evident how realistic the ECB’s assumptions were. It is clear though that the problems have not really been resolved as of yet. As one skeptical observer – incidentally a former insider, so to speak – put it (wondering why e.g. Germany’s banks are considered to be in fine fettle):

“Philippe Legrain, an economist and former adviser to then European Commission president José Manuel Barroso, described the tests as a “whitewash”. “The ECB singles out less important banks in less important countries and gives the German banks a clear bill of health,” Mr Legrain said.”

After an initial pop higher, the Euro-Stoxx Bank Index was down by 2.45% in early afternoon trading on Monday – click to enlarge.

Charts by: WSJ, Thomson-Reuters, 4-traders, BbigCharts