European bank stress tests: what to watch for

The European Banking Authority (EBA) releases the results of its 2016 health check on 51 lenders on Friday. Here are details of what to look for in the stress tests.

The test format

Unlike in previous years there will be no pass or fail. Instead the

European Central Bank

will use banks’ performances in the tests to set capital targets for them.

Analysts are likely to focus on whether a bank’s buffer of core capital is assessed to fall below 5.5 per cent if it were subject to a theoretical economic and financial shock. The EBA used this threshold in the 2014 tests to determine whether a bank was healthy or not.

Any bank missing that threshold will be under pressure from investors to boost its capital as quickly as possible.

Test scenario

The test’s “adverse scenario” looks at how banks could cope with four risks over three years: an abrupt rise in bond yields from very low levels in a market where liquidity is thin; poor profitability at banks in a weak economy; rising public and private debt concerns; and stress from a rapidly growing “shadow banking” sector. The test will also look at banks’ operational and conduct risk for the first time, assessing, for example, how well they could cope with a large fine by regulators for misconduct.

Potential weak spots

ITALY:

Italy’s banking system is the weakest among the large EU countries, with its lenders saddled with around €360 billion of bad debt.

It has four banks undergoing tests, with its third-largest lender, Monte dei Paschi, under the most pressure. Weighed down by around €50 billion in bad loans, there are expectations that the tests will find its capital levels insufficient to withstand a major economic shock.

Analysts at Barclays expect Monte dei Paschi to be the only bank to fall short of the 5.5 per cent core capital level in the tests under the most adverse economic shock scenario.

It has been pushing in the days leading up to the tests to come up with a plan to shore up its balance sheet, hoping to win approval from the ECB for proposals to sell off around €10 billion of its bad debt and raise €5 billion in fresh capital.

UniCredit, Italy’s largest bank, has been moving quickly to boost its capital levels following the appointment of Jean-Paul Mustier as chief executive on June 30th. As the only Italian bank categorised as a globally systemically important bank (G-SIB) by the Financial Stability Board, markets will be looking to see if its core capital levels exceed 6.5 per cent under the stress tests scenarios, as it is subject to a 1 percentage point capital surcharge due to its G-SIB status. Most analysts are confident it will achieve that.

GERMANY: Deutsche Bank, branded by the International Monetary Fund as the bank posing the biggest systemic risk to the global financial system, is also in the spotlight.

Its core tier 1 capital base has fallen over the past year, sliding from 11.4 per cent in June 2015 to 10.8 per cent at the end of last year, trailing that held by most of its investment banking rivals. This is much less than required by ECB regulators in the mid-term and also far from the bank’s own target of 12.5 per cent.

As a global systemically important bank, analysts will expect its capital levels to be at least 7.5 per cent, given that its G-SIB status means it is subject to a 2 percentage point capital surcharge.

This year’s stress tests also look at banks’ litigation risks. Since 2012, Deutsche Bank has run up more than €12 billion in legal bills to handle claims filed by individuals, companies and regulators over misselling or market manipulation. It has made provisions of €5 billion for future settlements. Analysts will want to see how much the stress test estimate of the bank’s litigation risks would dent its capital.

FRANCE: The capital levels of France's biggest bank, BNP Paribas, are under scrutiny. Like Deutsche, its G-SIB status means analysts will use 7.5 per cent as a rough benchmark for its capital level "pass mark".

Barclays analysts have flagged it, along with Monte dei Paschi, UniCredit and Deutsche Bank, as among the most vulnerable to posting a weak capital reading under the test scenarios.

However, it reported on Thursday it had a core tier one capital level of 11.1 per cent as of end-June, and said it was not worried about stress tests results.

What’s not in the tests

The EBA’s tests cover less than half of the 123 lenders covered in the last health check in 2014, meaning some areas seen as weak points in European banking are not covered this time.

None of Portugal’s banks will be included for example. Nor will any Greek banks, although the ECB did a comprehensive assessment of the country’s four biggest lenders in 2015.

The ECB has conducted tests on 56 other banks not looked at by the EBA. It won’t publish these results, although individual banks can do so if they want.