Treasury Today Country Profiles in association with Citi

Testing times for stressed out banks

The results of the European bank stress tests are due to be released today. After last year’s whitewash, expectations – and tensions – are running high. But what impact will the judgement have on treasurers?

Only seven banks of the 91 tested last year failed – that is, seven were expected to see their Tier 1 capital ratios fall below 6% when under stress. Nevertheless, several which passed the tests went on to need government assistance. Bank of Ireland and AIB, for example, passed the tests due to “robust, realistic and prudent capital standard[s] informed by detailed analysis and by emerging best practice internationally” – yet both needed bailouts before the year was out.

This year’s stress tests are using a lower Tier 1 capital threshold, at just 5%. However, the tests’ defenders claim the hypothetical stresses to which the banks are being exposed are more robust and will prove a better guide to future risks than last year’s did.

The tests’ strength may not be suitable to today’s situation, however, as they were drawn up before the sovereign debt crisis deepened. “Their effect will depend on how much they take into account the sovereign debt crises or merely assess the extent of possible trading losses,” says Treasury Risk Consultant at Moneycorp, Alex Lawson. “If it is just trading losses then that sounds a lot less comprehensive than, say, Italy defaulting on 10% of its debt. As they are, the tests might be somewhat lightweight.”

Ratings agency Moody’s echoed Lawson’s concerns: “The EBA’s 2011 stress assumptions do not assume a sovereign default at a time when the risk of a sovereign default within the euro area has increased. The tests will, however, incorporate additional measures of sovereign stress aimed at reflecting, somewhat, recent market developments, which is a step that enhances the credibility of the exercise.” And under this slightly-tougher regime, Moody’s predicts that 26 banks will fail the tests.

If that prediction comes true, what steps will the banks have to take to strengthen their positions? And what impact will that have on their corporate customers?

The most immediate impact is that the banks will have to raise more capital. “Failing banks will have to raise capital quickly,” says Nordea’s Head of Segment Corporate Merchant Banking, Claus Stehr. “They will become more selective in lending, only keeping on the most important and highest quality corporates.”

Bad news when corporates are already experiencing reduced availability and increased cost of credit as their banks move to meet the Basel III requirements. “Under pressure from regulatory authorities, banks have been repairing their balance sheets, but this has had a knock-on effect of restricting credit to businesses, slowing the recovery,” says Andy Baldwin, Senior Economic Advisor to Ernst & Young.

Many Greek banks are already widely regarded as being in poor shape – but if many Italian and Spanish banks fail the latest round of tests, confidence in their faltering economies and debt-laden governments, too, could be damaged. “If it is just a few small banks that fail the tests, the impact should be limited,” says Moneycorp’s Lawson. “But if any larger bank is in trouble the impact will be much greater. The level of detail shown in the reports could add to this. For example, if a large French bank fails – or is even just close to failing – investors will be less willing to put money in, the cost of borrowing will rise and it could precipitate a crisis.”

Banks that fail may have to be supported by their governments, putting further burden on government budgets at a time of uncertainty in the bond markets. With debt crises showing no signs of abating, this can only heighten fears about the stability of certain European states.

Treasurers can be proactive by working with strong, stable banking partners and looking to diversify funding sources, perhaps even tapping the bond markets. “We have a healthy balance sheet and expect to be approached by increasing numbers of corporates after the stress test results,” says Nordea’s Stehr. “But we will be selective, only taking strong clients who want a long-term relationship.”

The selection process will not be one way though: Ernst & Young believes that corporates will be able to do more analysis on partner banks as a result of the stress tests, to determine which fit their own risk appetites. “Banks will be required to disclose more details about the size of their exposures, which will help market participants to calculate the effect of larger stresses for themselves,” according to Senior Economic Adviser Marie Diron.

“So while we believe the stress test results are unlikely to significantly dampen risk aversion in the funding markets, enhanced clarity regarding the positions of banks should contribute toward reducing uncertainty,” she continues.

Preparation for any eventuality is necessary – if the euro is hit by a large bank failing the tests, the currency will weaken and sterling, too, according to Lawson, whilst the Swiss franc and US dollar will strengthen. But surprisingly good results could take the euro up again. “Regardless of the outcome, treasurers should hedge their positions properly,” Lawson explains. “The potential is there for the wheels to fall off at any time, as most market participants feel that some kind of default is inevitable, sooner or later.”