stress tests

How will sovereign bonds will be handled in the euro area’s forthcoming banking health checks? This is a vexed question and markets seize ravenously upon any clues.

Mario Draghi, the European Central Bank’s president, offered a flicker of information on Tuesday in a letter to Sharon Bowles, the chair of the European Parliament’s Economic and Monetary Affairs committee. Sovereign exposures will indeed bit included in the stress test, he said – confirming previous declarations from the ECB.

However, it is “not foreseen” that bonds in the held-to-maturity category of banks’ books will be adjusted to reflect market valuations – otherwise known as marked to market. That will come as a relief to banks that are holding portfolios that have slumped in value, but analysts caution that it is far too soon for lenders to relax. 

Markets remain nervous about Ireland after yesterday’s stress test results – despite the fact they appeared thorough and the €24bn recapitalisation they recommend matches expectations. This has prompted Europe’s biggest clearing house LCH.Clearnet to again raise the margin requirement on clearing of Irish debt, back up to 45bp from 35bp. Effectively, this increases the cost of holding Irish bonds and decreases the cost of shorting them.

Should all this post-stress-test stress lead to another downgrade, as seems likely, Dublin will be protected to a large degree by a lifeline from the ECB, which has pre-emptively suspended its collateral requirement for the country. 

Irish stress tests reveal a capital shortfall of €24bn, comprising:

  • Allied Irish – €13.3bn
  • Bank of Ireland – €5.2bn
  • Irish Life – €4bn
  • EBS – €1.5bn

Note: Anglo Irish Bank and Irish Nationwide Building Society were not included in the exercise because their loan books are being wound down. Anglo was fully nationalised in January 2009 and Nationwide is “effectively state-owned”. Both have required substantial state aid.

The headline figure of €24bn is better than many expected, particularly since about a fifth of it is for an additional capital “buffer” that goes beyond the 10.5 per cent tier one requirement in the base scenario, and 6 per cent requirement in the adverse scenario. Without this additional requirement, the recapitalisation requirement would be €18.7bn. The Irish central bank seems to have gone for the warts-and-all approach, which bodes well for the reliability of the numbers.

As well as raising new capital, banks will need to sell many of their non-core assets, following a deleveraging plan agreed with the central bank “in order to transition to smaller balance sheets and a more stable funding base”. They will separate assets into core and non-core, gradually selling off the latter. But shareholders, take heart: first, this will not be done in a hurry; second, the losses this will inevitably incur are already factored into the analysis: 

No stress tests for ages, then they all come along at once.

Some banks are set to raise their dividends imminently in the US, once the Fed gives them the green light ahead of detailed stress test results released in secret next month. Another practice put on hold in 2009 – share buybacks – will also be back on the menu for some of the 19 large banks. Only those groups that wanted to increase dividends or share buy-backs, or repay government capital, received a call from the Fed on Friday. Those receiving good news will no doubt act swiftly: any of these activities will presumably be seen as a public badge of honour, in the absence of results publication.

Europe, meanwhile, does intend to publish results. Arguably the target audience for Europe’s stress tests is investors and markets rather than the banks themselves. This might give the unfortunate impression that policymakers are aiming for the appearance of a healthy banking sector rather than the real thing. 

Irish banks may need more than the €10bn set aside for them in the bail-out, the Irish finance minister has said.

Michael Noonan said in Brussels today that recapitalising Irish banks could not take place till stress tests were completed, but that he would be “surprised” if €10bn were enough. The Irish Independent claimed over the weekend that “a further injection of between €15bn and €25bn could now be needed”. Mr Noonan told reporters he expected the size of the shortfall to be revealed by stress tests, whose results are due to be published by the end of March. 

The tests on 88 EU lenders holding 65 per cent of the bloc’s total assets over the coming months are structured to determine how well banks would hold up in a severe economic crisis. Criteria for banks’ passing or failing the test are due to be set next month.

The documents, seen by Reuters, show that the adverse scenarios include: 

Holdings of sovereign debt will be included in European stress tests, which will include country-specific adverse scenarios designed by the ECB. There was some doubt whether sovereign debt would be included after Cebs, the EBA’s predecessor, was reported in November saying it wasn’t “clear that a repeat of the sovereign risk sensitivity analysis will be necessary in 2011″. How times change.

Collaboration on methodology will begin tomorrow (Friday) between the EBA and individual countries’ supervisory bodies. Scenarios plus the sample of banks will be published March 18. Broad principles of stress test methodology are expected in April. Several months will be needed to complete the tests, which will be published in June. (Note: new US stress tests, which are due for completion this month, will not be published.) And what will happen should a bank fail? 

European stress tests will be held in the first half of this year and published in the summer, the European Banking Association* has announced. They will be accompanied by a review of liquidity funding risks:

The EBA will, as part of its regular cycle of risk assessments, initiate a separate thematic review of liquidity funding risks across the EU banking sector in the first quarter of 2011. The EBA will use this internal review to inform supervisory authorities about areas of vulnerability in relation to liquidity risk.

It looks as though the liquidity assessment will remain private, though the stress tests will be published. We’ve asked the EBA for confirmation and will update you.

No mention of the sovereign holdings part being scrapped; perhaps, in light of current shenanigans in Europe, the EBA felt they might be needed. 

To add to the prevailing sense of deja vu, regulators in both the US and Europe are this week discussing new banking stress tests. There is a significant difference with the new tests, however: they are to be part of regular, ongoing scenario analyses, and the results in the US, at least, will remain private. The first round of stress tests were public and aimed at reassurance.

The Federal Reserve is expected to start analysing data provided by 19 large banks this week, to work out how their balance sheets would withstand a variety of new shocks. “Only banks that have repaid government bail-outs and can prove a lifted dividend will not compromise their safety will be allowed to return cash to investors,” write Francesco Guerrera and Tom Braithwaite. “The Fed will also decide whether banks are on course to meet more stringent rules on capital requirements, agreed by the international Basel committee last year.” Tests are expected to be completed by March and are expected to be similar in content to those of May 2009. 

How did Allied Irish Banks pass the CEBS stress tests, but then require a bail-out from the Irish government? This is the question Labour MEP Alan Kelly is apparently to pose to EU competition commissioner, Joaquín Almunia.

There may be red faces at CEBS, the Committee of European Banking Supervisors, which organised the stress tests and published the results in July. Banks self-reported the numbers, based on a template with some EU-wide and some country-specific assumptions, and CEBS then cross-checked and peer-reviewed the data.