European Banking Authority and the capital of European banks: Don’t shoot the messenger

Marco Onado, Andrea Resti 07 December 2011

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The newborn European Banking Authority (EBA) has been fiercely criticised in the first few months of its life. According to many observers:

  • This summer’s stress tests were ineffective; and
  • The October rise in capital ratios to 9% has raised concerns about a massive credit crunch

We think these criticisms are off the mark. As happens to regulators, analysts are in the process of shooting the messenger because they don’t like the message.

 Criticism 1: The July stress tests were “inherently flawed”

Many analysts judged the July stress tests too mild, mainly because they did not explicitly factor in a default of Greek sovereign debt (P Jenkins 2011, Wyplosz 2011). But this misses the point. The EBA stress tests were a great step forward from the point of view of disclosure. For the first time, markets could see full information on each bank’s exposures, by country, debtor type, and maturity. Moreover, funding costs of individual institutions were disclosed, both historical and in the adverse scenario.

The information provided had a significant impact on stock market prices in the days immediately following the publication of the results. In particular, in the three days following the publication of the results (before the July 21 agreement on Greek debt losses blurs the picture) tested banks saw their stock prices rise significantly more than untested ones. Most meaningfully, about 50% of the extra returns recorded by individual tested banks can be explained by a few simple profitability and resilience indicators based on stress-test data, including eligible core Tier 1 capital, the increase in credit losses and funding costs under the downturn scenario and the coverage ratio on bad loans at end 2012 (Petrella and Resti 2011).

Funding costs are one of the most important explanatory variables. This seems rather obvious, as European banks have huge funding gaps (ie, differences between loans and deposits plus other retail sources) that make interest margins very sensitive to market rates. Stress-test results thus were positive for the European banks in terms of capital, but worrying in terms of profitability, as highlighted even by a mere qualitative analysis (Onado 2011).

This is why we believe that the stress tests were effective. They revealed the true Achilles’ heel of many European banks – over-reliance on wholesale funds. Ask Dexia for further details (Pignal 2011).

Criticism 2: EBA’s stress tests have been less effective than the tests conducted by the Fed in 2009

There is no doubt that, unlike the US exercise, European stress tests failed to reassure the markets, Here critics seem to have a point.

  • Why did the first stress-test results sooth the widespread panic, reversing the downward trend in bank stock prices?
  • Why did Dexia have to be rescued after getting a clear bill of health in terms of capital adequacy?
  • Why was the EBA forced to run a new ‘pseudo stress test’ (focusing on sovereign debt holdings only and based on a simplified set of assumptions) only three months later?

A comparison of the European stress tests to the 2009 US exercise (Supervisory Assessment Capital Program) provides an explanation. The US administration wholeheartedly stood behind the stress-test results, mandating undercapitalised banks to quickly raise extra funds and providing those funds when needed and assuring the market that public capital would have been available in case of need.

European governments did not reach an agreement on this point and could not give any precise commitment. Even worse, they still appear bent on the same mistakes. The decision by the Council late in October and the subsequent statements by Eurozone leaders still show limited willingness to endorse the stress-test results (even those revised to account for stronger sovereign losses) by putting taxpayers’ money at stake.

Criticism 3: EBA capital increase creates a credit crunch

The argument can be reversed. Again the problem is the freezing of the European bond market that has already significantly impaired the funding ability and triggered a credit crunch. Suffice it to remember that in 2011 European banks have sold $413 billion of unsecured bonds, equivalent to just two thirds of the $654 billion that is due to be returned to investors in 2011 (with a $241 billion funding gap). Adding covered bonds, the gap drops to $144 billion, but is far from closed. Morgan Stanley estimates that next year some €700 billion of term funding will be needed to roll over existing liabilities; a daunting figure in light of the issuance data for June-October 2011, when average monthly inflows were well below €20 billion (see Figure 1).

Figure 1. Bond issuance in Europe

Source: Morgan Stanley

The credit crunch has already begun and can be reversed only if banks are soon able to tap the markets as usual. The EBA seems to be only too aware of this problem as its president recently declared that “the fact that so far only the EBA’s measures to strengthen bank capital have been publicly put forward is for us a source of real concern” (Enria 2011). But even the press release whereby the ‘recap’ package was announced stated explicitly: “Notwithstanding the ECB’s support for banks short term funding needs, additional steps are required to restart the term unsecured funding market. This would help banks to continue their lending activities in 2012 and to avoid a spiral of forced deleveraging and the ensuing credit crunches, which would affect the real economy”,

In the EBA approach, “additional steps” are not limited to capital increases. The authority urged the European Council not only to promote higher capital levels, but also to promote integrated guarantees on term funding and break the bank/sovereign loop by providing an adequate backstop to the peripheral countries’ crisis. Only the first of those three measures was approved, leading to an unbalanced (and possibly ineffective) recipe for bank recovery which caused outspoken concern even to the EBA. Thus what should have been a three-legged stool now only has one leg.

Criticism 4: The EBA’s request for a new round of capitalisation is “absurd” and must be dropped

This position does not take into account that European banks have a lower level of capital than their competitors in the US. Based on 2010 data, the top six US banks had an average Tier 1 ratio of 13.2%, compared to 12.1% for their EU counterparts; if one looks at Europe’s top twelve banks (as it may be appropriate to account for Europe’s higher fragmentation), that would further drop to 11.4%. In terms of leverage, the difference is even more striking. Some big European banks have a capital base which is a meagre 2 or 3% of their total assets.

The European banking system faces two emergencies: in the short term, restore trust to restart lending; in the medium term, restructure their its swollen balance-sheets and restore profitability. An orderly recapitalisation is an essential component of this process, along with the other measures envisaged by the EBA. Simply dropping the EBA request would still leave banks in a desperate need for wholesale funds, and could not reduce the risk of massive deleveraging and credit crunch.

There is, however, a chance that banks manage to cut risk-weighted assets (improving capital ratios) without actually shrinking their loan portfolios. This looks like an ideal world, but has its own risks. To make ends meet, banks should soften their internal risk management models and get them validated (ie, acceptable for regulatory purposes) within a few months. In this way, the same assets would command a lower capital requirement (that is, the same amount of capital as today would be magnified when scaled by lower risk-weighted assets).

There is a risk that some supervisors may succumb to such pressures, since the plan looks like an acceptable compromise between the need to signal increased strength to investors and the wish not to let bank borrowers down. Still, the dangers of such unfair competition among national supervisors cannot be overstated. The level playing field – the goal of two decades of EU regulation – would be seriously undermined from inside. Also, it would not take much for investors to learn about the trick (and we hardly need further motives for market distrust)!

Conclusions

All the facts recalled above point in the same direction. The current market turmoil (sometimes described as an unwanted consequence of the euro) must be addressed by stronger European integration, not by a return to national selfishness. A pan-European guarantee scheme for banks, a ’big bazooka’ for sovereign debt which does not boil down to a pop gun, stronger bank supervision at the EBA level– these are the steps to be taken, if only someone in Berlin and Paris could move.

Most of the criticisms to the EBA request have been driven by lobbying interests more than by noble worries on the future of the European economy. As Robert Jenkins (2011), now member of the Financial Policy Committee of the Bank of England recently stated, “The banking lobby has responded by blaming Basel. […] In short the latest lobby tactic is to convince pundits, public and politicians that encouraging prudence too soon will hit the economy too hard. This is no longer amusing. This strategy is intellectually dishonest and potentially damaging”.

References

Alloway, T (2011), “Europe’s banks feel funding freeze, Financial Times, November 27.

Enria, A (2011), “Regulatory outlook for EU banks and the implications for corporate lending”, speech at the Standard & Poor’s Conference “The Future of Corporate Funding”, London, 23 November.

Jenkins, P (2011) “Europe stress tests undermined by indecision”, Financial Times, July 18.

Jenkins, R (2011), “Lessons in Lobbying”, Bank of England, 22 November.

Onado, M (2011) “European stress tests: Good or bad news?”, VoxEU.org, 16 August.

Petrella G and A Resti (2011), “Do Stress Tests reduce Bank Opaqueness? Lessons from the 2011 European Exercise”.

Pignal S (2011), “S&P downgrades Dexia divisions”, Financial Times, October7.

Pignal S (2011), “Ailing Dexia’s €6.3bn third-quarter losses”, Financial Times, November 7.

Wyplosz, C (2011), “Resolving the current European mess”,VoxEU.org, 25 October

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Topics:  EU policies Financial markets

Tags:  Credit crunch, stress tests, European Banking Authority

Marco Onado

Professor at Bocconi University, Milan and former Commissioner of the Italian public authority responsible for regulating the Italian securities market (CONSOB).

Andrea Resti

Associate Professor, Bocconi University