European banks are more resilient to wheather future crises

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November 10th, 2014

In October the ECB and the EBA published the results of the comprehensive assessment of Europe's banks as a prior step to the start of the Single Supervisory Mechanism which sets up the ECB as the euro area's single banking supervisor as from November.

This analysis of the health of the balance sheets and solvency of Europe's banks consisted of two sequential exercises: an asset quality review (AQR) and a stress test. As a result of both, a maximum capital deficit has been identified totalling around 24.6 billion euros, located in 25 of the 130 banks analysed. After taking into account the measures adopted by these banks throughout 2014, this deficit falls to about 9.5 billion euros and is concentrated in just 13 banks: four Italian, two Greek, two Slovenian, one Irish, one Portuguese, one Belgian, one Cypriot and one Austrian. These banks must present their recapitalisation plans by 10 November and have six to nine months to increase their top quality capital (common equity tier1 or CET1).

The AQR entailed an adjustment to the capital position at the beginning of the stress test. The detailed review of balance sheets in December 2013 included an assessment of asset quality and the appropriateness of the level of provisions based on a harmonised definition of bad debt. Under this new definition, loans totalling 136 billion euros (equivalent to 0.6% of the total assets for the the banks examined) have been reclassified as non-perfoming, resulting in a need for larger provisions and an adjustment of the average CET1 ratio by 0.4 pps. The difference with regard to the 8% capital threshold translates into a total capital shortfall at the starting point of around 5 billion euros. The AQR has had most impact on Greece, Cyprus and Slovenia with reductions in the CET1 ratio of more than 2 pps. Spain, on the other hand, had the least adjustment in the euro area, with a fall of just 0.2 pps in CET1. This reflects the efforts made to clean up balance sheets and the adoption of highly conservative asset classification criteria by the Spanish financial system over the last few years.

Taking the AQR-adjusted CET1 as the starting point, the stress test analysed the ability of banks to withstand two macroeconomic scenarios for the period 2014-2016 (one baseline scenario and one adverse). On average, the result in the adverse scenario was a fall of 3 pps in banks' CET1. In those banks whose capital ratio falls below the 5.5% threshold set for this scenario, this impact leads to an aggregate capital shortfall of just over 24 billion euros. The effect of the adverse scenario on the Spanish banking system was less than the average for Europe: the CET1 ratio only fell by 1.4 pps and none of the banks analysed went below the 5.5% threshold which, once again, demonstrates the ambitious restructuring carried out by Spain's banks.

On the whole, the results are positive for Europe's banks and particularly for Spain, to such an extent that they will help to dispel doubts regarding solvency levels because the capital requirements are relatively modest (no country expects to resort to significant state aid). It should be noted that most banks, accounting for more than 70% of all banking assets in the euro area, would have a CET1 ratio above 8% in the adverse scenario (this happens in 13 of the 15 Spanish banks analysed). These are banks that can be considered to have passed the test with very high marks. Only nine banks in the euro area have passed by a narrow margin (CET1 of between 5.5% and 6.5%, and none of these is Spanish.

Improved confidence in European banks should ease their access to the markets and reduce their cost of equity. The results, as they eliminate the uncertainty regarding possible demands for capital from the supervisor, should also encourage banks to grant more loans. Nonetheless, for there to be a significant recovery in credit, doubts also need to be dispelled regarding the economic outlook for the euro area as a whole, with the economic recovery picking up. The exercise carried out by the ECB and the EBA reveals that, particularly in Spain, the banking sector is ready to meet the demand for solvent credit and to accompany this recovery.