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Analysis

Capital backing still in fragile state

by Michael Lafferty

Capital backing still in fragile state

Neither the euro area not the UK’s banking system is materially short of capital, says the European Central Bank and the Bank of England, in separate assessments. Both claims need to be treated with caution. Europe’s banks are still in a very fragile state.

According to the ECB, only €9.5bn of additional capital needs to be raised by 13 mainly smaller banks among the 130 largest in the euro area to bring them into line with the 2014 stress requirements. This is the message from the ECB before it took a new supervisory role for euro area banks in November.

The starting point for the ECB assessment was an asset quality review, which showed an overvaluation of bank assets of €47.5bn at 31 December 2013 – hardly significant for an exercise covering €22tn of assets. The most significant adjustments were required in Italy, Greece, Germany, Austria, Netherlands, France and Spain – many of the ‘usual suspects’ when it comes to accounting waywardness.

The AQR required the banks to have a minimum so-called CET1 equity capital ratio of 8% at end-2013. This was then stress-tested against two hypothetical scenarios. Under the baseline scenario, banks were required to maintain a minimum CET1 ratio of 8%. Under the highlydemanding adverse scenario, they were required to maintain a minimum CET1 ratio of 5.5%.

Under the adverse scenario the ECB found that the 130 banks’ aggregate available capital would be depleted by €215.5bn (22% of capital held by participating banks) and risk-weighted assets (RWA) increased by about €860bn by 2016. Including this as a capital requirement at the threshold level brings the total capital impact to €262.7bn in the adverse scenario. Startling as a 22% capital depletion may seem, the big euro area banks still have a median capital ratio of over 8% in the adverse scenario – and each bank needs a capital ratio of only 5.5% to pass. (By way of comparison, the UK adverse stress tests found that the capital ratio of the eight banks concerned would be reduced from 10% in 2013 to 7.3% in 2015, or 7.5% if certain management actions were implemented.)

This is how the ECB’s comprehensive assessment identified a capital shortfall of only €24.6bn across 25 participating banks after comparing these projected solvency ratios against the thresholds defined for the exercise – 8% for 2014 and 5.5% in 2016. Thanks to various capital-raising and other initiatives only 13 banks need to raise an additional €9.5bn to become compliant. On past experience such a capital-raising will not be a problem. Between the financial crisis in 2008 and 31 December 2013, capital in excess of €200bn has been raised by 130 banks that were stresstested. Since 1 January 2014, a further €57.1bn has been raised. This helps explain why the capital shortfall identified by the stress test is only €9.5bn. The second part of the 2014 European bank stress tests came in midDecember, when the Bank of England reported that all but one of the eight banks tested – the hapless Co-operative Bank – had passed, though two others would also have failed if they had not taken or committed to corrective action before the exercise was complete. For both banks, this action included raising or exchanging several billions of debt that automatically converts to common equity in the event that a bank falls below a minimum capital ratio.

Lloyds, which currently claims a Tier 1 ratio of 12%, would achieve only 5% on the adverse stress test – and a mere 5.3% even if it took further strategic management actions. It attained 5% partly by exchanging certain Tier 2 capital instruments into £5.3bn of AT1 ‘high-trigger’ securities in April 2014. RBS, currently claiming a 10.8% capital ratio, achieves only 4.6% on the adverse test and a slightly better 5.2% if it implements certain strategic actions in the future. The Bank of England points out that there is a substantial variation in the eight banks’ leverage ratios, which fall from 3.6% at end-2013 to a low point of 3.4%.

While the ECB and Bank of England stress test methodologies have much in common, they do differ in their definitions of what counts as capital. The UK has used fully-implemented Basel III, the ECB has not, preferring phased-in numbers. This has an enormous effect – and according to one commentator means that many euro area banks will have to find additional equity to add a further 2% to their aggregate capital ratios even before the regulator introduces further buffer requirements. This shows that the stress tests are an approximate exercise, just one of the tools for assessing the health of Europe’s banks.

Inevitably, there are concerns about the adequacy of the bad debt provisioning of many European banks – from Italy’s Monte de Paschi to the UK banks, and Barclays in particular. Despite economic growth since 2008, which has outstripped that of France, loan quality in the U.K. is worse and the coverage ratios even at the largest banks are not impressive. The 29% bad debt coverage ratio at Barclays at end-2013 compares with almost 70% at RBS, a level which would wipe an additional £10bn off the £64bn of shareholders’ funds at Barclays at the end of 2013 – and reduce its capital ratio dramatically.

There can be little doubt that Europe’s banks remain in a fragile state – one from which it will take them many years to recover. Some will not survive in anything like their current structure. Others will simply be absorbed by stronger banks, or liquidated.

Far too many European banks have shattered business models, are poorly managed or run for the benefit of management and operate in protected home markets where all too often they end up delivering poor customer service and little or no profit to shareholders. The worst excesses revealed so far have been in Britain but there is evidence that similar levels of misconduct such as misselling of products (often manufactured in the investment bank) have been taking place in countries like Germany and Italy too. ■ Mark Carney, governor of the Bank of England Michael Lafferty is chairman of the Lafferty Group.

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