European Banks: Leverage and Stress Tests

• European banks have high leverage ratios, indicating a large amount of debt relative to equity.

Leverage

• Leverage is the ratio of a company's debt to its equity.
• Equity functions as a risk buffer, absorbing losses before they affect debtholders.
• High leverage during the Global Financial Crisis (GFC) meant banks had insufficient equity to absorb losses.
• This led to global decisions to limit banks' leverage ratios and the implementation of stress tests.

Stress Tests

• Stress tests assess the ability of financial institutions to withstand adverse market conditions and systemic risk
• Adverse market developments include rising interest rates, unemployment, and market volatility.
• Rising interest rates can lead to more expensive loans, slower consumer spending, reduced stock values, and higher debt costs.

Core Tier 1 Capital

• Core Tier 1 capital is a measure of a bank's financial strength, consisting of common equity and retained earnings.
• A scenario analysis, such as mortgage loans losing value, assesses the impact on a bank's balance sheet and equity.
• A drop in the equity ratio indicates a reduced ability to buffer losses.

2011 EU-Wide Stress Tests

• The first EU-wide stress test, issued by the European Banking Authority (EBA), had a CORE tier 1 capital ratio threshold of 5%.
• Eight banks fell below this threshold, with a capital shortfall of 2.5 billion.
• The EBA later raised the threshold to 8% by the end of 2011.

2012 Assessments

• The EBA published assessments in 2012, requiring banks to address shortfalls through direct capital measures.
• Banks strengthened balance sheets by reducing bonus payments, issuing new equity, and increasing retained earnings.
• A review indicated that banks effectively managed balance sheet risks through these measures

Bankia and EU Stress Tests

• During the GFC, the housing bubble burst in Spain, leading to a severe banking crisis.
• Bankia claimed to have significantly increased its CORE tier 1 capital ratio.
• Bankia requested a bailout of 19 billion in May 2012 due to fraudulent accounting practices.
• The falsifications were accepted by managers, auditors, and the Spanish financial secretary, pushing the Spanish banking sector to near collapse.
• Spain sought up to 100 billion in European rescue money for its banks.
• This situation led to the creation of the Single Supervisory Mechanism (SSM) by the European Banking Union.

2014 Stress Tests, Asset Quality Review (AQR), and SSM

• The Single Supervisory Mechanism (SSM) was the first building block of the European Banking Union (EBU).
• National-level supervision was deemed insufficient, necessitating a centralized, uniform approach.
• The ECB directly supervises large banks, while smaller banks are supervised nationally.
• The Asset Quality Review (AQR) was conducted by the SSM in 2014 with objectives:
• Enhanced supervision: More accurate evaluation of Europe's banks before ECB supervision.
• Transparency: Increased transparency in banks' balance sheets and risk exposure.
• Standardized stress tests: Defining starting values for better comparison
• Supervisory credibility: Strengthening ECB's credibility.
• The implementation included:
• Focus on equity rather than liquidity.
• Stricter NPL (non-performing loan) classification: 90 days overdue loans unlikely to be repaid.
• AQR helped fix the issue with NPL reclassification.
• AQR results:
• Troubled loans were higher than reported in 2011 stress tests.
• Stress test spanned three years with different thresholds: 8% (baseline) and 5.5% (adverse).
• Banks increased their equity due to stress tests, improving financial stability. There were some criticisms

2016 Stress Tests

• Unlike previous stress tests, 2016 had no specific threshold.
• Average CET1 ratios were not alarming; however, there were large discrepancies.
• Monte dei Paschi, the world's oldest bank, had a negative CET1-ratio and was insolvent in an adverse scenario.
• Nordic countries performed well.
• Stress tests led to nearly doubled CET1 capital ratios, indicating success.

Capital Ratios by Country (Q1 2023)

• Capital ratios still vary across countries.
• The EU has higher NPL rates, especially in Southern European countries due to local challenges and high unemployment.
• EU has slower economic growth and a more fragmented banking system with many small to medium-sized banks.
• This fragmentation prevents banks from achieving the same economies of scale as in the US.

Reduction of NPL

• Overall, NPL amounts have decreased.
• Spain, which once had around 20% NPLs, has reduced it to about 4%.

Net Interest Income (NII)

• Net Interest Income is the difference between interest revenue and interest expenses.
• Europe faces stagnant margins, indicating persistent challenges in bank profitability.
• Reference rates do not directly influence NII, However, Impact on Banking profitability as it reduces the margin between loans and deposits
• This issue is worsened by the floor on deposits being at 0%.
• Recent years have seen improvements, with NII increasing by roughly a third.
• Europe generally trades at a price to operations below 1%, as it does not have an upper hand than the US, which is above 1%.
• US raised capital over EU
• Major change in banking markets.

New Stress Tests

• Include Climate Stress Tests: Assessing banks' resilience to climate-related risks.
• Cyberattack Stress Tests: Testing banks' abilities to withstand cyberattacks.
• Bank credibility is essential, and customers must trust them; banks are investing heavily in cybersecurity.

European Banking Union

• Comprises three main building blocks:
• Single Supervisory Mechanism (SSM): ECB and national supervisory authorities; the ECB directly supervises large banks.
• Single Resolution Mechanism (SRM): Managed by the European resolution fund to minimize costs to taxpayers.
• European Deposit Insurance Scheme (EDIS): Covering all bank deposits up to 100,000 EUR, though not yet finalized.

The Capital Markets Union

• Some countries like Germany and Finland are opposed to pooling financial risks due to concerns about excessive risk-taking (moral hazard).
• Europeans tend to rely on banks for borrowing, whereas American companies more often issue bonds, a more developed financial market than the US.
• One of Europe's main issues is a lack of financing options; most money is in bank accounts.
• Bank lending may not be optimal for high-risk ventures, which could cap funds for innovative projects and slow down economic growth.
• The Capital Markets Union was formed to increase the amount of risky financial assets.
• Getting financing for risky projects is a lot harder.
• Europe needs stronger capital markets to provide more options for financing.
• Reducing reliance on bank funding would make the financial system more resilient.
• There was some progress of financing in England, compared to Germany, but has now been slowed down due to Brexit.
• If we fail to increase the availability of risky lending, we slow down economic growth.
• The final stages of financing are in the capital markets.

Explore leverage ratios in European banks and their impact. Learn about stress tests and their role in assessing financial institutions' resilience to adverse market conditions. Understand Core Tier 1 capital and its significance in measuring a bank's financial strength.