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How are the European bank stress tests like a butterfly?
We think we know — thanks to Deutsche Bank’s take on the Spanish banks’ stress-test results on Monday.
Deutsche have probed the provisions on loan losses, and in particular, pre-provision profits kicking in beforehand, that banks were allowed during stressed scenarios.
Seems a pretty technical point. But it’s not, when you’re talking about Spanish banks. After all, the Bank of Spain has long prided itself on its dynamic, macro-prudential rules to make lenders provision for future loan loss.
So over to Deutsche Bank’s analysts to help blow a hole in this canard (emphasis ours):
We regard the impairment assumptions (both on sovereign and the different credit buckets) as sufficiently severe and consistent. We are, however, less convinced by and have lower visibility on what is included in and how the regulator arrived at some of its forecasts on PPP [pre-provisioning profit], capital gains and other "impairment buffers". This is particularly relevant as under a marginally tougher set of assumptions in this area, a larger number of institutions would have failed the test (nine instead of five, with another six below 6.5% Tier 1), although admittedly the incremental amount of capital is limited to E3.5bn.
Now, as Deutsche point out, loan loss reserves unsurprisingly play a large role on Spanish bank balance sheets, and they were all used up in the tests:
As seen in Figure 7, the Spanish system has E69.9bn of loan losses on the balance sheet (50% of which are specific provisions and the other 50% generic). Of this amount, saving banks represent 44.6% (E31.2bn). We agree with the assumption of full utilization of the loan loss provisions, as under this theoretical stress test, all NPLs would be either lost or recovered, bringing down the default rate to zero.
And about a third of gross impairments are provisioned, system-wide:
Hence the importance of where you stand profit-wise before provisions kick in. Odd then, that the Bank of Spain was markedly more generous for certain Spanish banks than the stress-test heads CEBS themselves, when it came to forecasting available pre-provision profit — as the following chart shows (click to enlarge):
While as Deutsche Bank add:
…we must assess the severity of the PPP assumptions under the "adverse scenario". Bank of Spain claims that the average PPP for the period 2010-2011 (under the "adverse scenario") has been stressed by 30% in relation to the figure recorded in 2009 (40% in the case of the saving banks). We are not sure how Bank of Spain arrives at those declines, but according to the data provided, we estimate an average of 16-18% (see Figure 11)[below, click to enlarge]. Our impression is that this may be perceived as insufficient.
Quite. Reducing the PPP forecasts by 20 per cent leaves nine banks below the magic 6 per cent Tier 1 capital ratio used in the tests, according to Deutsche Bank.
None of which is especially mind-blowing. (Although it feeds the argument that banks should have faced a higher Tier 1 capital requirement, or a more stringent definition of Tier 1, such as core equity, in the first place).
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Test like a butterfly, stress like a bee
But the change in outcome is palpable, and that’s worrisome for what it says about both future stress tests in Europe, and about the future of macro-prudential tools like loan-loss provisioning.
In short, both are beholden to the butterfly effect — small differences in initial conditions lead to big changes in the final outcome, in this case Tier 1 capital ratios.
The analogy isn’t quite exact, because we’re dealing with designed, not dynamical systems in either case. Although you could argue finance has a grim tendency to ditch design for out-of-control dynamics in the end anyway.
In which case — even the limited upside that Felix found in the stress tests, that regulators will cooperate more in future, seems, well, limited. Not if idiosyncratic national rules like loan-loss provisioning can sway the end result quite profoundly.
And secondly — just in case you think all financial reform needs is a quick dash of macro-prudence; well, best to check the details on the packet, first.
Related links: Under Stress – Edward Hugh / Fistful of Euros European Stress Test reax round-up – Long Room What does Spanish bank stress look like in real life? – FT Alphaville
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