- Monday brought more clarity to the banking industry.
- The Basel Committee released their revised and still-tentative agreement for global bank rules, aimed at discouraging banks from taking "excessive risks."
- Meanwhile, the private sector started crunching numbers on the European bank stress tests.
- Even using more "stressful" criteria, European banks prove to be overall healthy.
Monday brought still more clarity to the banking industry. The Basel Committee (a regulatory organization in charge of international bank rules), released a revised (and still tentative) agreement aimed at discouraging banks from taking "excessive risks." (Though, what "excessive risks" exactly are remains elusive.) The agreement is much weaker than its predecessor proposed in December. That only seems fair since banks have gotten themselves in better shape since then—all without global accord. (Further details on the final agreement should materialize in the coming months.)
Meanwhile, though European banks passed last week's stress tests (done by the Committee of European Banking Supervisors—CEBS) with flying colors, the criteria came under fire by some for not being stringent enough. Fair enough, but as we noted, they were more stringent than the US stress tests last year. Still, in the coming weeks, the private sector will probe many more scenarios—a process that shines yet more clarity on bank health—and we welcome it. Indeed, quick on the draw, Goldman Sachs (GS) conducted its own stress tests—which were more exacting still than the CEBS criteria. The result? Banks held up just fine and, for the most part, performed better than the €38 billion capital shortfall expected prior to the tests.
To start, the CEBS subjected banks to a 6% Tier 1 capital ratio (liquid bank assets divided by risk weighted assets)—7 institutions failed and needed, in aggregate, to raise €3.5 billion. When Goldman raised the ratio to 7%, 24 banks failed and needed to raise a total of €11.3 billion—and when raised to 8% (an unlikely scenario, in our view), 39 banks would fail and need to raise €30.2 billion—still less than the €37.6 billion the market was expecting. In other words, the worst scenario turned out not nearly as grim as folks widely expected.
Additionally, to address specific complaints the CEBS tests assumed sovereign debt losses only applied to trading assets and not those intended to be held to maturity, GS extended sovereign debt haircuts across banks' entire balance sheets. The result? Banks fared worse than the original tests (as would be expected), but less so than feared. The total loss would apply mostly to Greek banks, not the whole of Europe. And, overall, the number of institutions failing the test increases to 21, with €16 billion needing to be raised. Plus, for this scenario to even be realistic, there would need to be an actual default or accounting rules would have to change (i.e., it was a bit far-fetched.)
And if Greece actually did default (despite the massive joint IMF/EU/ECB bailout package and pretty darn unlikely at this point) and banks only recovered 40% of their funds? 17 banks would fail the test, and the capital needed would increase to €28 billion. Again, not as bad as expected, with failures contained mostly to Greece.
Finally, the last scenario tested banks using Core Tier 1 ratios instead of Tier 1 ratios—or only the highest quality assets on a bank balance sheet. Ten of the 37 banks tested would come up short at a 6% capital threshold—but only €3.7 billion of fresh capital would be required. About the same amount as needed under the CEBS.
We can bicker till the cows come home about what to test, but the longer the data is public, the less jittery markets should be as they exhaust all scenarios themselves. And since potential trouble in euro-land has been a recurring theme this year, the alleviation of those fears should be a welcome—and bullish—change.