By Jane Winterbottom – firstname.lastname@example.org
Over the seven-year period since the financial crisis of 2007, banking-industry participants and commentators have been calling for a shake-up, or perhaps more appropriately, a clean-up, of the banking industry. This is not only to provide stability and security to global capital markets and the international economy but also to bring much-needed and overdue stability to the banking institutions themselves. One measure being put in place to avoid the same fate as Lehman Brothers and Bear Sterns by banks across the globe is that of stress-testing.
Inadvertently, or otherwise, global banks alongside their sector peers were holding billions of dollars of unhealthy asset positions on their balance sheets. These institutions were financing huge amounts of low-quality debt, and when the financial system collapsed, it was hoped that write-downs would be put in place to reconcile loans that have no hope of ever being repaid. Instead of applying these write-downs, many banks have merely plodded along. These banks have not taken the required action – in terms of write-downs but also in terms of making new loans towards financing growing business areas. The climate of caution and hesitancy has meant that many banks have allowed themselves to be cosseted by politicians and regulators in their choices. In addition, bank decision-makers are also now more alert than ever to the demands of shareholders. This is not always a good thing as inaction in key business areas can lead to banks taking on less risk, even risks with attractive risk-reward ratios – and this can be damaging to profits and balance sheets. This type of paralysis, if left unchecked, will damage the health of the banking industry into the future and threaten to diminish sustainable business activity.
Consequently, earlier this year, the European Banking Authority (EBA), a coordinator of national regulators across Europe, has taken steps towards forcing banks to clean up their balance sheets – as part of their Comprehensive Assessment of the banking sector. The EBA has outlined the details of testing that it will administer; however, in the main, the stress tests have been designed to assess a bank’s ability to survive economic downturns and various shock scenarios across global capital markets. The concept and tool of stress-testing is not new – with a previous set of recommendations being proposed in 2011. However, the success of this implementation was far from satisfactory – with many of the banks passing these stress tests with flying colours going on to suffer significant damage from market shocks only months later. Understandably, investors and market participants have been sceptical as to the effectiveness of applying periodic stress-testing to banks in assessing the health and stability of these institutions. Especially as this prior failed phase of testing fed the uncertainty and climate of low confidence that had taken grip at that time. This further compounded the banks’ poor health situations by lowering their ability to raise high-quality capital through the sale of shares or through bond issuance.
However, the recently announced stress tests will be significantly more rigorous. The health of banks’ balance sheets will be considered under tougher market-shock scenarios – under various deep economic and financial shocks to assess the banks’ ability to weather the conditions. Under the new stress-testing, EU lenders will have to demonstrate an ability to withstand a global debt-market sell-off, spikes in funding costs, a new recession and deep falls in property and equity prices, amongst other shock circumstances. As a specific example, the tests will apply a model of a sharp rise in bond yields and a 2.1-percent fall in economic output over a three-year period. This is much greater than the mild 0.4-percent drop considered over a two-year period under the 2011 series of stress tests. This stress-testing is designed to act as a central pillar of European regulatory change designed to restore credibility to the region’s banking sector.
Further to this, individual nations will factor in particular circumstances of concern within their geographic marketplace that should be incorporated when assessing bank health in that particular country. For example, in the UK, a significant fall in housing prices is a serious concern to the wider economy – the banking industry especially. Further to this, following the EBA announcement, The Bank of England announced its own set of specific additional parameters for stress-testing of UK-based lenders to address country-specific issues.
A further characteristic of the new set of stress tests will specifically address the risks of holding sovereign bonds. The more realistic and severe risks of holding sovereign bonds will be taken into account, whereas under previous testing, this area was practically unexplored – with many assuming an asset value equal to price paid for these bonds.
The changes in stress-testing will create a tougher climate for assessing bank health, and this will serve their stability and sustainability in the long run. The proposed asset-quality review (AQR) to be carried out by the European Central Bank later in 2014 will also help serve this purpose. Sceptics may still be dubious about whether this phase of stress-testing will indeed be any better than the last phase in 2011. However, one clear signal that the stress tests will be different and tougher this time around is the increasingly expressed discontent against them. Banks are assessing the tests and realising that drastic change will have to be made to satisfy the test parameters, and this is fuelling the row about the implementation of these stress tests. European banks are being forced into writing off bad debts and will have to raise upwards of €35 billion (US $49 billion) in capital in order to pre-empt the results, which are due in October, alongside the changes that will be required from the application of the AQR. As a notable example, Deutsche Bank, Germany’s largest bank, has recently announced plans to raise 8 billion Euros (£6.5 billion) through share issuance in order to strengthen its balance sheet ahead of the upcoming October stress tests. Most of the 128 participating banks within the EBA and ECB area of supervision have been vastly reducing their risky assets and increasing regulatory capital ahead of the testing.
Gaps highlighted by the stress test will have to be filled within nine months of the results. Regulators have imposed limits on the use of additional high-quality “tier one” capital instruments in filling these gaps. The ECB has stated that banks tested will be expected to cover capital shortfalls revealed by its Comprehensive Assessment within six to nine months after the release of ECB results, which are due for publication later this year. Further to this, any shortfalls revealed by the AQR or the baseline stress-test scenario will have up to six months to be covered – and may only be met through common equity.
The stress-test market-shock scenarios being proposed by the European Central Bank (ECB) and the EBA will prove very demanding for some participating banks – which is exactly their intention. Although concerning for bank bosses, and often difficult and costly to orchestrate, these kinds of sweeping changes are needed to restore long-term health to the banking sector, and many would argue that they are long overdue.