Description
"There is obviously the risk that if too many banks pass and do so with a comfortable margin, the test may be judged as too easy to have actually been informative about the strength of the banking system, and markets may not draw any new comfort or optimism from the exercise,"
European Weekly Analyst
Issue No: 10/27 July 22, 2010
Goldman Sachs Global Economics, Commodities and Strategy Research at https://360.gs.com
On the eve of the bank stress tests
Erik F. Nielsen [email protected] +44 (0)20 7774 1749 Nick Kojucharov [email protected] +44 (0)20 7774 1169
While we wait for tomorrow’s release of the European stress tests of the banks, we take a look back at what has been a very good week for European growth prospects. We opened Q3 with much stronger than expected Eurozone PMIs, mostly because of Germany. Importantly, orders in Germany are increasingly coming from domestic demand rather than from exports. French business confidence was also stronger than expected, all together promises well – if still very early – for Q3 GDP growth. We also got solid industrial production numbers for June out of Poland and better-than-expected retail sales in the UK. But what will tomorrow’s stress tests show? While people will probably read into the release whatever they want to read, our bank analyst colleagues will publish their immediate take tomorrow right after the release, and a more detailed analysis before Monday morning. Meanwhile, we provide an overview of what is know – and what is expected – of the stress tests in a Q&A format in this publication. The test will cover 91 banks in 20 countries, which collectively account for 65% of total assets in the EU banking system. The system will be tested against an adverse scenario of a -3% growth deviation from the baseline for the EU as a whole, and assets will be marked down, although that may not apply to sovereign securities held in account to maturity. As such, the stress test may not go far enough, but the additional transparency coming out of this exercise will surely be welcome.
%, qoq
PMI-based indicator points to GDP growth of +0.7%qoq at the start of Q3
1.2 0.7 0.2 -0.3 -0.8 -1.3 -1.8 -2.3 -2.8 98 99 00 01 02 03 04 05 06 07 08 09 10 Actual GDP Survey-based coincident Indicator
Source: Eurostat, GS Global ECS Research
%
Banks' capital ratios close to post-97 highs
7.6 7.4 7.2 7.0 6.8 6.6 6.4 6.2
Editor Erik F. Nielsen [email protected] +44 (0)20 7774 1749
97 98 99 00 01 02 03 04 05 06 07 08 09 10
Source: ECB
Important disclosures appear at the back of this document
Goldman Sachs Global Economics, Commodities and Strategy Research
European Weekly Analyst
The ins and outs of the Bank Stress Tests: A Q&A Guide
On this eve of the eagerly-awaited European bank stress tests, details about the underlying assumptions and scenarios used are still hard to come by, which is somewhat ironic given that that a core aim of the exercise was to bring clarity to the cloud of uncertainty that currently prevails, and to promote transparency in the banking system. To bring our readers up to speed on the little information that is available, we have compiled a brief Q&A guide to what we think are the key issues. 1. Why are banks being stress tested? Over the past few months, European banks have seen sharp rises in their funding costs and a significant sell of their equity. Uncertainty about the capital positions of these banks has certainly been a driver of this negative market reaction, but, as we discussed in detail in last week’s European Weekly Analyst 10/26, the close correlation between bank CDS and sovereign CDS in recent months (Chart 1) suggests that concerns about the sovereign debt situation have also contributed significantly. The relative scarcity of information about all these risks and exposures has engendered a lack of trust within the system, and polluted investors ability to distinguish the good banks from the bad ones. The stress tests are an active effort by the authorities to address this prevailing uncertainty and distrust, and are partly guided by the belief that analogous tests in the US a year ago were a catalyst for the improvement in public sentiment. Although officially the aim is to “assess bank’s ability to absorb further credit and market shocks” and to gauge “their dependence on public support measures,” we think the real power of the tests is the increased clarity and transparency that they will bring. 2. Who is conducting the tests? The Committee of European Banking Supervisors (CEBS) and the national banking authorities are taking the lead in coordinating the design and implementation of the test, in cooperation with the ECB. In line with its mandate, the CEBS regularly monitors and tests the
Chart 1: Strong correlation between protection on European banks and sovereign
5-yr CDS Spread, bps iTraxx Senior European Financials
vulnerabilities of the banking sector, but this is the first time the results of these analyses will be released to the public on such a wide scale. 3. How many banks are involved and in which countries? The test will cover 91 banks in 20 countries, which collectively account for 65% of total assets in the EU banking system.1 This sample is noteworthy in that it is designed to cover at least 50% of each national banking sector, and to incorporate a significant share of public banks (most notably the German Landesbanks and Spanish Cajas) for which we have the least financial clarity. 4. When will the results be released? The CEBS will publish the results tomorrow on both an aggregated and bank-by-bank basis starting at 18:00 CEST. A press conference will follow an hour later. 5. What are the “stresses” applied and are they harsh enough? The resilience of banks will be tested under two macroeconomic scenarios –baseline and adverse – each of which assumes a predetermined path for key economic and financial variables. The CEBS has not revealed the full range of variables, but GDP, unemployment, inflation, and interest rates are the ones explicitly mentioned (presumably house prices will also play an integral role). Details about the magnitudes of the various parameters and their differences between the two scenarios are also sparse, but we do know two tidbits: The baseline GDP path for each country will be the European Commission’s latest economic forecast for 2010 and 2011 (Table 1). The adverse scenario will then assume a -3% growth deviation from this baseline for the EU as a whole, but we don’t know how this 3% shock will be distributed among the member states. To simulate an increase in sovereign risk, the test will (if we understand it correctly) mark down sovereign securities to prices observed at the trough of the selloff in May of this year.
250
200
150
100
50
Weighted ave. of European sovereigns
0
07
08
08
09
09
10
We think the GDP shock used in the adverse scenario is sufficiently negative to generate significant hits to banks’ loan books and other portfolio holdings, and is actually
Source: GS Global ECS Research, Datastream
1. The omitted EU countries are Bulgaria, Czech Republic, Estonia, Latvia, Lithuania, Romania, and Slovakia. Banking groups which have crossborder subsidiaries and branches will be grouped together and tested on a consolidated basis.
Issue No: 10/27
3
July 22, 2010
Goldman Sachs Global Economics, Commodities and Strategy Research
European Weekly Analyst
Table 1: European Commission growth forecasts
2010 Austria Belgium Bulgaria Cyprus Czech Denmark Estonia Finland France Germany Greece Hungary Ireland Italy Latvia Lithuania Luxembourg Malta Netherlands Poland Portugal Romania Slovakia Slovenia Spain Sweden UK Euro-zone EU
Source: European Commission
2011 1.6 1.6 2.7 1.3 2.4 1.8 3.8 2.1 1.5 1.6 -0.5 2.8 3 1.4 3.3 3.2 2.4 1.7 1.8 3.3 0.7 3.5 3.6 1.8 0.8 2.5 2.1 1.5 1.7
6. Are losses to banks sovereign securities the only market shock considered? No, but it is the only shock for which we have any logistical details, even though it is probably the least important. Indeed, sovereign securities account for only about 5% of total assets on Euro-zone bank balance sheets, while the bulk are in the form of loans (57%), corporate securities (13%), and other assets (25%). In this sense, although sovereign debt exposure will be an important determinant of banks’ vulnerability to adverse shocks, we think their ability to pass the stress tests will primarily be a function of their resilience to credit hits on their loan portfolios. For a 3% drop in GDP growth, our best estimate is that resulting credit losses would amount to 1.5% of loans on aggregate EU balance sheets, or 0.7% of total assets (see European Weekly Analyst 10/26). 7. What benchmarks will be used to determine who “passes”? Banks generally carry protection against credit and trading losses in the form of credit and capital buffers. The former refers to the retained earnings and reserves that banks have over and above what they have already provisioned for expected losses, while the latter is defined as the stock of capital that banks hold in excess of the minimum legal requirement. As far as we know, the CEBS and other parties conducting the stress test have not set a credit buffer threshold under which banks will be deemed to be “at risk.” The main test criterion therefore appears to be a capital buffer, and according to the FT and other sources, the minimum tier 1 capital ratio used to assess this buffer will be 6%. Banks that fall short of this ratio will have raise additional capital, although there is no deadline specified at this point. 8. Isn’t this benchmark capital ratio too low? It is difficult to determine an “appropriate” threshold ratio – i.e. one that does not overstate the buffer of banks who are actually undercapitalized, but is at the same not too strict so as to force too many banks to go through the costly process raising new capital. That said, in the context of the European banking system, we do feel a 6% threshold ratio is a bit on the low end, and our bank analysts estimate that, at this ratio, very few banks will fail the stress test, and will, on average, be able to sustain a cumulative loss 10.2% on their loans (4.7% of total assets).3 9. How should the results be interpreted? If a bank passes, does it mean it is solvent? Not necessarily. Since the passing rate of banks will be a function of performance criteria and assumptions used in
1.3 1.3 0.0 -0.4 1.6 1.6 0.9 1.4 1.3 1.2 -3.0 0.0 -0.9 0.8 -3.5 -0.6 2.0 1.1 1.3 2.7 0.5 0.8 2.7 1.1 -0.4 1.8 1.2 0.9 1.0
even more severe than the assumption used for the US bank stress tests in 2009.2 The shock to sovereign securities is somewhat limited in the sense that it stress tests only for trading (i.e. mark-tomarket) hits and not for losses to securities which banks may have in their hold-to-maturity portfolios. But given that the focus of the exercise is on regulatory capital, and gains and losses on the hold-to-maturity books are generally not counted as part of this capital, the design of the shock is reasonable.
2. The baseline case in the US assumed GDP growth of -2.0% in 2009, and 2.1% in 2010. These were marked down to -3.%3 and 0.5%, respectively, in the adverse scenario. 3. See Europe: Banks
Issue No: 10/27
4
July 22, 2010
Goldman Sachs Global Economics, Commodities and Strategy Research
European Weekly Analyst
the exercise, banks which are deemed financially sound under these parameters may obviously fail under alternative specifications. 10. So does that mean that even “successful” results will not restore some order in financial markets? There is obviously the risk that if too many banks pass and do so with a comfortable margin, the test may be judged as too easy to have actually been informative about the strength of the banking system, and markets may not draw any new comfort or optimism from the exercise. But if the test assessment criteria turn out to be objectively strict and the simulated shocks sufficiently “stressful”, then there may certainly be due cause for believing that the banking system is in better shape than most analysts believe. In any case, we think the main value of these stress tests in the first place is not the ultimate pass/fail marks assigned by the CEBS, but rather the clarity gained from having detailed and consistent information (capital positions, loss estimates) about the banks under consideration (especially the less transparent public banks). Such information should allow investors and market participants to better distinguish between banks, and, at the minimum, identify those which are at the extremes of the risk spectrum. This ability to separate the clearly good from the clearly bad will be important in mitigating problems of adverse selection, and thus keep
risk premia and funding costs rise for the system as a whole from rising. 11. Do we have any indication of the results so far? Although they will not be officially confirmed until tomorrow, recent comments by various European officials and press agencies suggest that the overwhelming majority of tested banks passed, and that the required capital raising will be limited. Spanish Minister of Finance Salgado, for example, announced on Tuesday that of the 8 private banks and 18 cajas tested, none failed, and that the Spanish banking will therefore not require additional capital.” This statement did not seem to jive with various outside estimates that anticipated capital raising in the range of €10-50bn (the IMF assumed €22bn in its worst-case scenario), but the Spanish newspaper El Economista reported today that the discrepancy seems to come from the fact that the Bank of Spain has allowed banks to count funding from its FROB facility as tier 1 capital.4 In any case, the balance of news is still consistent with better-than-expected stress test results, and so far we have only heard of two banks as being reported to have failed – the German bank HRE, and the Slovenian bank NLB. Nick Kojucharov
4. Funds for Orderly Bank Restructuring (FROB) take the form of preference shares (non-cumulative and subject to the existence of distributable reserves), yielding 7.75% in the first year, which is set to increase by 15bp in each of the following 4 years (i.e., 8.35% in the fifth year), and by 100bp thereafter. Therefore, should savings banks be able to repay such “loans”, FROB Funding would finally compute as “capital”, but if –on the contrary- any of the savings banks fail to make the payments and default, it is unclear whether FROB Funding will still compute as Tier 1 capital.
Issue No: 10/27
5
July 22, 2010
doc_554275471.pdf
"There is obviously the risk that if too many banks pass and do so with a comfortable margin, the test may be judged as too easy to have actually been informative about the strength of the banking system, and markets may not draw any new comfort or optimism from the exercise,"
European Weekly Analyst
Issue No: 10/27 July 22, 2010
Goldman Sachs Global Economics, Commodities and Strategy Research at https://360.gs.com
On the eve of the bank stress tests
Erik F. Nielsen [email protected] +44 (0)20 7774 1749 Nick Kojucharov [email protected] +44 (0)20 7774 1169
While we wait for tomorrow’s release of the European stress tests of the banks, we take a look back at what has been a very good week for European growth prospects. We opened Q3 with much stronger than expected Eurozone PMIs, mostly because of Germany. Importantly, orders in Germany are increasingly coming from domestic demand rather than from exports. French business confidence was also stronger than expected, all together promises well – if still very early – for Q3 GDP growth. We also got solid industrial production numbers for June out of Poland and better-than-expected retail sales in the UK. But what will tomorrow’s stress tests show? While people will probably read into the release whatever they want to read, our bank analyst colleagues will publish their immediate take tomorrow right after the release, and a more detailed analysis before Monday morning. Meanwhile, we provide an overview of what is know – and what is expected – of the stress tests in a Q&A format in this publication. The test will cover 91 banks in 20 countries, which collectively account for 65% of total assets in the EU banking system. The system will be tested against an adverse scenario of a -3% growth deviation from the baseline for the EU as a whole, and assets will be marked down, although that may not apply to sovereign securities held in account to maturity. As such, the stress test may not go far enough, but the additional transparency coming out of this exercise will surely be welcome.
%, qoq
PMI-based indicator points to GDP growth of +0.7%qoq at the start of Q3
1.2 0.7 0.2 -0.3 -0.8 -1.3 -1.8 -2.3 -2.8 98 99 00 01 02 03 04 05 06 07 08 09 10 Actual GDP Survey-based coincident Indicator
Source: Eurostat, GS Global ECS Research
%
Banks' capital ratios close to post-97 highs
7.6 7.4 7.2 7.0 6.8 6.6 6.4 6.2
Editor Erik F. Nielsen [email protected] +44 (0)20 7774 1749
97 98 99 00 01 02 03 04 05 06 07 08 09 10
Source: ECB
Important disclosures appear at the back of this document
Goldman Sachs Global Economics, Commodities and Strategy Research
European Weekly Analyst
The ins and outs of the Bank Stress Tests: A Q&A Guide
On this eve of the eagerly-awaited European bank stress tests, details about the underlying assumptions and scenarios used are still hard to come by, which is somewhat ironic given that that a core aim of the exercise was to bring clarity to the cloud of uncertainty that currently prevails, and to promote transparency in the banking system. To bring our readers up to speed on the little information that is available, we have compiled a brief Q&A guide to what we think are the key issues. 1. Why are banks being stress tested? Over the past few months, European banks have seen sharp rises in their funding costs and a significant sell of their equity. Uncertainty about the capital positions of these banks has certainly been a driver of this negative market reaction, but, as we discussed in detail in last week’s European Weekly Analyst 10/26, the close correlation between bank CDS and sovereign CDS in recent months (Chart 1) suggests that concerns about the sovereign debt situation have also contributed significantly. The relative scarcity of information about all these risks and exposures has engendered a lack of trust within the system, and polluted investors ability to distinguish the good banks from the bad ones. The stress tests are an active effort by the authorities to address this prevailing uncertainty and distrust, and are partly guided by the belief that analogous tests in the US a year ago were a catalyst for the improvement in public sentiment. Although officially the aim is to “assess bank’s ability to absorb further credit and market shocks” and to gauge “their dependence on public support measures,” we think the real power of the tests is the increased clarity and transparency that they will bring. 2. Who is conducting the tests? The Committee of European Banking Supervisors (CEBS) and the national banking authorities are taking the lead in coordinating the design and implementation of the test, in cooperation with the ECB. In line with its mandate, the CEBS regularly monitors and tests the
Chart 1: Strong correlation between protection on European banks and sovereign
5-yr CDS Spread, bps iTraxx Senior European Financials
vulnerabilities of the banking sector, but this is the first time the results of these analyses will be released to the public on such a wide scale. 3. How many banks are involved and in which countries? The test will cover 91 banks in 20 countries, which collectively account for 65% of total assets in the EU banking system.1 This sample is noteworthy in that it is designed to cover at least 50% of each national banking sector, and to incorporate a significant share of public banks (most notably the German Landesbanks and Spanish Cajas) for which we have the least financial clarity. 4. When will the results be released? The CEBS will publish the results tomorrow on both an aggregated and bank-by-bank basis starting at 18:00 CEST. A press conference will follow an hour later. 5. What are the “stresses” applied and are they harsh enough? The resilience of banks will be tested under two macroeconomic scenarios –baseline and adverse – each of which assumes a predetermined path for key economic and financial variables. The CEBS has not revealed the full range of variables, but GDP, unemployment, inflation, and interest rates are the ones explicitly mentioned (presumably house prices will also play an integral role). Details about the magnitudes of the various parameters and their differences between the two scenarios are also sparse, but we do know two tidbits: The baseline GDP path for each country will be the European Commission’s latest economic forecast for 2010 and 2011 (Table 1). The adverse scenario will then assume a -3% growth deviation from this baseline for the EU as a whole, but we don’t know how this 3% shock will be distributed among the member states. To simulate an increase in sovereign risk, the test will (if we understand it correctly) mark down sovereign securities to prices observed at the trough of the selloff in May of this year.
250
200
150
100
50
Weighted ave. of European sovereigns
0
07
08
08
09
09
10
We think the GDP shock used in the adverse scenario is sufficiently negative to generate significant hits to banks’ loan books and other portfolio holdings, and is actually
Source: GS Global ECS Research, Datastream
1. The omitted EU countries are Bulgaria, Czech Republic, Estonia, Latvia, Lithuania, Romania, and Slovakia. Banking groups which have crossborder subsidiaries and branches will be grouped together and tested on a consolidated basis.
Issue No: 10/27
3
July 22, 2010
Goldman Sachs Global Economics, Commodities and Strategy Research
European Weekly Analyst
Table 1: European Commission growth forecasts
2010 Austria Belgium Bulgaria Cyprus Czech Denmark Estonia Finland France Germany Greece Hungary Ireland Italy Latvia Lithuania Luxembourg Malta Netherlands Poland Portugal Romania Slovakia Slovenia Spain Sweden UK Euro-zone EU
Source: European Commission
2011 1.6 1.6 2.7 1.3 2.4 1.8 3.8 2.1 1.5 1.6 -0.5 2.8 3 1.4 3.3 3.2 2.4 1.7 1.8 3.3 0.7 3.5 3.6 1.8 0.8 2.5 2.1 1.5 1.7
6. Are losses to banks sovereign securities the only market shock considered? No, but it is the only shock for which we have any logistical details, even though it is probably the least important. Indeed, sovereign securities account for only about 5% of total assets on Euro-zone bank balance sheets, while the bulk are in the form of loans (57%), corporate securities (13%), and other assets (25%). In this sense, although sovereign debt exposure will be an important determinant of banks’ vulnerability to adverse shocks, we think their ability to pass the stress tests will primarily be a function of their resilience to credit hits on their loan portfolios. For a 3% drop in GDP growth, our best estimate is that resulting credit losses would amount to 1.5% of loans on aggregate EU balance sheets, or 0.7% of total assets (see European Weekly Analyst 10/26). 7. What benchmarks will be used to determine who “passes”? Banks generally carry protection against credit and trading losses in the form of credit and capital buffers. The former refers to the retained earnings and reserves that banks have over and above what they have already provisioned for expected losses, while the latter is defined as the stock of capital that banks hold in excess of the minimum legal requirement. As far as we know, the CEBS and other parties conducting the stress test have not set a credit buffer threshold under which banks will be deemed to be “at risk.” The main test criterion therefore appears to be a capital buffer, and according to the FT and other sources, the minimum tier 1 capital ratio used to assess this buffer will be 6%. Banks that fall short of this ratio will have raise additional capital, although there is no deadline specified at this point. 8. Isn’t this benchmark capital ratio too low? It is difficult to determine an “appropriate” threshold ratio – i.e. one that does not overstate the buffer of banks who are actually undercapitalized, but is at the same not too strict so as to force too many banks to go through the costly process raising new capital. That said, in the context of the European banking system, we do feel a 6% threshold ratio is a bit on the low end, and our bank analysts estimate that, at this ratio, very few banks will fail the stress test, and will, on average, be able to sustain a cumulative loss 10.2% on their loans (4.7% of total assets).3 9. How should the results be interpreted? If a bank passes, does it mean it is solvent? Not necessarily. Since the passing rate of banks will be a function of performance criteria and assumptions used in
1.3 1.3 0.0 -0.4 1.6 1.6 0.9 1.4 1.3 1.2 -3.0 0.0 -0.9 0.8 -3.5 -0.6 2.0 1.1 1.3 2.7 0.5 0.8 2.7 1.1 -0.4 1.8 1.2 0.9 1.0
even more severe than the assumption used for the US bank stress tests in 2009.2 The shock to sovereign securities is somewhat limited in the sense that it stress tests only for trading (i.e. mark-tomarket) hits and not for losses to securities which banks may have in their hold-to-maturity portfolios. But given that the focus of the exercise is on regulatory capital, and gains and losses on the hold-to-maturity books are generally not counted as part of this capital, the design of the shock is reasonable.
2. The baseline case in the US assumed GDP growth of -2.0% in 2009, and 2.1% in 2010. These were marked down to -3.%3 and 0.5%, respectively, in the adverse scenario. 3. See Europe: Banks
Issue No: 10/27
4
July 22, 2010
Goldman Sachs Global Economics, Commodities and Strategy Research
European Weekly Analyst
the exercise, banks which are deemed financially sound under these parameters may obviously fail under alternative specifications. 10. So does that mean that even “successful” results will not restore some order in financial markets? There is obviously the risk that if too many banks pass and do so with a comfortable margin, the test may be judged as too easy to have actually been informative about the strength of the banking system, and markets may not draw any new comfort or optimism from the exercise. But if the test assessment criteria turn out to be objectively strict and the simulated shocks sufficiently “stressful”, then there may certainly be due cause for believing that the banking system is in better shape than most analysts believe. In any case, we think the main value of these stress tests in the first place is not the ultimate pass/fail marks assigned by the CEBS, but rather the clarity gained from having detailed and consistent information (capital positions, loss estimates) about the banks under consideration (especially the less transparent public banks). Such information should allow investors and market participants to better distinguish between banks, and, at the minimum, identify those which are at the extremes of the risk spectrum. This ability to separate the clearly good from the clearly bad will be important in mitigating problems of adverse selection, and thus keep
risk premia and funding costs rise for the system as a whole from rising. 11. Do we have any indication of the results so far? Although they will not be officially confirmed until tomorrow, recent comments by various European officials and press agencies suggest that the overwhelming majority of tested banks passed, and that the required capital raising will be limited. Spanish Minister of Finance Salgado, for example, announced on Tuesday that of the 8 private banks and 18 cajas tested, none failed, and that the Spanish banking will therefore not require additional capital.” This statement did not seem to jive with various outside estimates that anticipated capital raising in the range of €10-50bn (the IMF assumed €22bn in its worst-case scenario), but the Spanish newspaper El Economista reported today that the discrepancy seems to come from the fact that the Bank of Spain has allowed banks to count funding from its FROB facility as tier 1 capital.4 In any case, the balance of news is still consistent with better-than-expected stress test results, and so far we have only heard of two banks as being reported to have failed – the German bank HRE, and the Slovenian bank NLB. Nick Kojucharov
4. Funds for Orderly Bank Restructuring (FROB) take the form of preference shares (non-cumulative and subject to the existence of distributable reserves), yielding 7.75% in the first year, which is set to increase by 15bp in each of the following 4 years (i.e., 8.35% in the fifth year), and by 100bp thereafter. Therefore, should savings banks be able to repay such “loans”, FROB Funding would finally compute as “capital”, but if –on the contrary- any of the savings banks fail to make the payments and default, it is unclear whether FROB Funding will still compute as Tier 1 capital.
Issue No: 10/27
5
July 22, 2010
doc_554275471.pdf