An update on the European bank stress tests

Guest contributor – Tamara Burnell (Head of Financial Institutions, M&G Credit Analysis team)

The publication of the Committee of European Banking Supervisors (CEBS) stress tests proved exactly the damp squib that most had been expecting. There was some additional useful disclosure on sovereign risk exposures (apart from a few German banks) but a decided lack of rigour in the regulatory approach. In total, only 7 “already failed” banks failed the tests. So all in all, the banking system passed the easy tests with flying colours, but at the same time is still on central bank life support and not strong enough to tolerate harsh regulatory proposals designed to prevent another crash. How does that work?

Indeed, since it was governments and regulators who were arguably being “tested” by the market, it is primarily the regulators who were the main “fail” candidates in this process. All they succeeded in doing was proving that the EU banking sector is too weak to be able to have a hope of meeting harsher Basel 3 capital and liquidity requirements by 2012. Stressing the banks to such a low hurdle (a 6% Tier 1 ratio after only relatively minor asset stresses) made it clear that regulators knew they were in no position to enforce Basel 3 on schedule. So it was unsurprising that the stress test results were followed almost immediately by an announcement from Basel that implementation of some of its key measures are being delayed until 2018, and that several measures were being significantly watered down. Indeed some cynics might argue that this was what CEBS had been trying to do all along, i.e. push Basel into changing its approach, to protect European narrow economic interests.

Banks (and regulators) seem to hope that by delaying regulatory reforms they will create positive sentiment around the banking sector. Indeed it has prompted something of a positive short term story in equity and credit markets, with banks seeing the opportunity to maintain their high leverage and asset liability mismatches for that much longer, and bearish investors have started to capitulate and accept that they can’t maintain an underweight position in banks until 2018. However, this positive momentum is unlikely to be sustainable – the problems faced (namely overleveraged banks, sovereigns and economies, all with a huge refinancing hurdle to overcome in the next 3 years) have not been tackled, and the issues facing bank creditors remain unresolved.

The key question now is whether the political and institutional will is still strong enough to demand radical changes to the way banks operate, and, in particular, to the way that bank creditors are treated in times of crisis. Although cosmetically Basel has made some concessions to ensure that changes to capital and liquidity requirements don’t precipitate the funding crisis they were designed to avert, behind the scenes some radical proposals are gathering steam. Regulators and politicians around the world continue to demand that next time around bondholders are the capital providers of last resort, rather than the taxpayer, and to this end regulators have been tasked with coming up with Resolution Regimes for global banks. As we see in corporate restructurings, debtholders usually have to recapitalise a company to maximise their recoveries – via a debt for equity swap or some sort of debt forgiveness – and a similar restructuring process is now being proposed for banks, so that existing creditors “bail-in” failed banks. This will require major legislative change and a change in mindset from market participants, so it can’t happen quickly.

Ultimately these changes will lead to bond investors being far more careful about which banks they lend to and at what price, which could force a painful contraction in bank balance sheets. But we continue to believe that in the long-term the costs of not reforming the banking system and perpetuating the “too big to fail” assumption would be far greater (another crash) than the benefit of the status quo (high leverage, large asset liability mismatches, poor liquidity, high returns). So we still believe that important, painful and far-reaching reforms will be made, even if the global economy and banking system are not robust enough to tolerate these changes now.

Regulators are faced with only tough choices. Do they force through the big bang changes now, with the possibility that we re-enter a full-blown bank funding crisis? Or do they give the banks and their creditors more time to adjust to the coming changes? The latter would be done in the hope that by the next time we have a banking crisis we will have a system whereby even senior unsecured bank creditors could see principal write down or debt-for-equity swap features that help to recapitalise failing bank institutions when it is most needed (unlike the recent crash when there was no such support provided by debt-holders of banks).

The banking regulatory and investment landscape is changing. And it is changing for the better: another crash will be less likely and the costs will be borne to a greater extent by all stakeholders, rather than just shareholders and taxpayers. It is just not changing quite yet.