European stress tests confirm FDR Framework

Bloomberg ran an article confirming yet another prediction under the FDR Framework.  In particular, the article confirms the prediction that market participants will analyze the most recently disclosed data and use the results of this analysis to exert market discipline.

In this particular case, market participants analyzed the European stress tests and their related data disclosure and are now requiring specific banks to raise more capital.

Deutsche Bank AG (DBK), Royal Bank of Scotland Group Plc (RBS), Societe Generale SA and UniCredit SpA (UCG) may face pressure from investors to boost capital after scraping through Europe’s banking stress tests. 

Deutsche Bank, Germany’s largest bank, had a core Tier 1 capital ratio of 6.5 percent under the test’s adverse scenario. While that surpassed the 5 percent fail rate, it ranked eighth among the 12 German banks that participated and 57th overall among the 90 banks tested. Edinburgh-based RBS had a ratio of 6.3 percent, Societe Generale of Paris 6.6 percent and Milan- based UniCredit 6.7 percent...

“Since the stress tests did not include any sovereign debt failure, some view them as not being stringent enough,” said Espen Furnes, an Oslo-based fund manager at Storebrand Asset Management, which oversees $74 billion. “If we see sovereign defaults, many of the large banks like Deutsche, SocGen and RBS will need new capital. These banks should strengthen their capital base to curb investor worries.”

Deutsche Bank, Societe Generale (GLE) and UniCredit said their capital ratios would have been higher had regulators recognized all the steps they were taking to increase reserves...

JPMorgan Cazenove analysts led by Kian Abouhossein said in a note after the test that as many as 20 banks may need to raise as much as 80 billion euros of additional capital to help allay investor concern over a Greek default. 

“The EBA tests give a lot of transparency and it looks like some of the banks, even if they did pass the 5 percent capital ratio minimum level, will likely need to boost their capital to regain market confidence and investors’ trust,” said Jonathan Fayman, a fund manager at BlueBay Asset Management Plc in London, which oversees about $43 billion....

Deutsche Bank said on July 15 that the stress tests failed to reflect the bank’s plans to reduce risk-weighted assets and retain earnings, as well as the “sound economic environment” in Germany. The company plans to reach a target for a core Tier 1 ratio above 8 percent by 2013 under Basel III rules. A spokesman declined further comment. 

By reducing risk-weighted assets, a bank can bolster its capital ratio. 

“I don’t expect Deutsche Bank to make a capital increase,” said Konrad Becker, a Munich-based analyst at Merck Finck & Co. “You have to look at the reason for the 6.5 percent ratio and it is not because of sovereign risk. It is mainly because of risk-weighted assets linked to derivatives and other assets.” 

Chief Executive Officer Josef Ackermann, 63, told reporters in Cernobbio, Italy, in April that the company is “well capitalized.” The Frankfurt-based bank raised 10.2 billion euros last October in its biggest-ever share sale to finance a bid for a controlling stake in Deutsche Postbank AG and meet stricter capital rules for banks. 

Societe Generale, led by CEO Frederic Oudea, 48, would have had a core Tier 1 ratio of 7.5 percent under the adverse scenario had the tests taken into account its first-quarter results, an option to pay dividends in shares, the annual capital increase reserved to employees and the reduction of capital allocated to risky assets, according to a statement on July 15. The bank reiterated that the ratio will climb to at least 9 percent in 2013 under Basel III. Spokeswoman Laetitia Maurel declined to comment. 

Berenberg Bank analysts including Nick Anderson said in a note yesterday that the EBA’s methodology was “relatively harsh” on RBS as it assumed a static balance sheet after 2010, ignoring the bank’s plans to sell holdings including its insurance unit to reduce assets by a further 10 percent by the end of 2012. 

RBS spokesman Michael Strachan declined to comment. The bank, run by Stephen Hester, 50, since November 2008, required a government rescue after piling up the most losses of any European bank during the financial crisis, according to data compiled by Bloomberg. 

“The bottom line is that the role of capital in a bank is not properly understood, putting pressure on banks to hold more capital rather than less in the future,” the Berenberg analysts said in the note. “The debate is now in the hands of politicians, the media and the markets, all now armed with stress test data.” ...

“The stress tests conducted showed that although only eight banks failed, several of the larger European banks are thinly capitalized,” said Furnes at Storebrand Asset Management.

Real value of European stress tests lies in disclosure

A David Enrich article in the Wall Street Journal discussed how the European Banking Authority saw the real value of the stress tests lying in disclosure.

As previously discussed, the disclosure did not go far enough.

The WSJ article makes the case for why current asset and liability-level disclosure is needed by focusing on loans that banks have made to countries experience sovereign debt problems.  Without knowing how the individual loans are performing or are collateralized, market participants are left to make worse case assumptions about the value of the loans given the sovereign debt problems.

Europe's banks are sitting on vast quantities of loans to individuals and businesses in cash-strapped Southern European countries, highlighting how plain-vanilla loans, not just government debt, pose potential risks to the Continent's troubled banking system. 

The holdings are detailed in disclosures Europe's largest banks made as part of the European Union "stress tests," whose results were announced Friday...

But officials with the European Banking Authority, the regulator that conducted the tests, argue that the real value of the exercise is the mountains of data—about 3,200 pieces—each bank was required to reveal about its balance sheet. That includes detailed, country-by-country breakdowns of the types of loans and securities on their books. 

During Europe's 15-month financial crisis, investor and analyst fears have centered largely on banks' holdings of sovereign debt issued by governments in financially shaky countries such as Greece, Ireland and Portugal. If those countries were to default, it could saddle banks and other holders of their bonds with big losses. 

But Friday's test results shed light on another potential problem for Europe's banks: huge piles of residential mortgages, small-business loans, corporate debt and commercial real-estate loans to institutions and individuals from ailing countries. As those economies struggle, the odds of rising defaults grow. 

Banks tend to be holding far greater quantities of those commercial and retail loans than they are of sovereign debt, according to a Wall Street Journal analysis of disclosures accompanying the stress tests. 

This year's stress tests represent the first time there has been a uniform way to measure this exposure. Until now, banks have disclosed their portfolios of loans to customers in troubled countries on a piecemeal basis. That made it virtually impossible to aggregate data across the industry or to compare different institutions. 

"The country-by-country exposure [data] is better than any data we've seen before," said Alastair Ryan, a London-based banking analyst with UBS AG. "It's giving me more things to be fearful of," Mr. Ryan added, referring to the disclosures of some banks' large holdings of loans to customers in troubled countries...

The stress-test figures actually understate some banks' holdings of loans in certain troubled countries. That is because the European Banking Authority required banks to disclose their loan holdings in countries only if they represent more than 5% of the bank's total loan exposures. 

As a result, some banks opted not to disclose details of their loan portfolios. 

In protecting their information monopoly, Eurozone regulators make crisis worse

The Telegraph ran an article on the European Banking Authority and the stress tests that confirms everything your humble blogger has said about regulators gambling with financial market stability by protecting their monopoly on all the useful, relevant information on banks' current asset and liability-level data.

Andrea Enria, chairman of the EBA and other officials of the London-based organisation, fielded questions from analysts angered at what were quickly described as an "inadequate" set of tests. 

Mr Enria is understood to have outlined the difficulties the EBA faced in conducting the stress tests on the 91 European banks that took part. He was asked why just nine banks failed, requiring total new capital of €2.5bn (£2.2bn). 

The EBA was clear in methodology papers it released on Friday that it had faced great difficulties getting different national regulators and banks to provide accurate data. 

Describing the process as "constrained", the EBA admitted that figures given by the banks in some cases "materially" changed after being challenged. "It is clear the EBA is telling us it was unable to perform the type of tests it wanted to and considering the difficulties it faced it didn't do a half bad job," said one market professional. 

The previous two paragraphs need to be re-read as they document financial regulators directly contributing to financial market instability by not making the data available so that the risk of the banks they are supervising could be analyzed.

As a result of the national regulators' efforts, the ability of the market to accurately distinguish between solvent and insolvent banks is compromised.

Criticism of the tests was largely on the loss assumptions it used for banks' sovereign exposures. 

For instance, the EBA required banks only to take a 15pc loss on holdings of Greek government debt, even though the bonds are currently trading in the market at about half their face value. 

"There may be doubts over the credibility of the EBA's ability to conduct a thorough stress test since it appears to have avoided tackling the thorny issue of banks' exposures to sovereign debt," said Syed Kamall, a Conservative MEP and a member of the economic and monetary affairs committee. 

"The exposure of banks to sovereign debt is the giant elephant in the room and ignoring this issue could undermine the credibility of these tests," he added. 

However, the EBA's document makes it clear that it wants national regulators to force the banks to prepare for the eventuality of a severe worsening in the crisis, even a sovereign default. 

"A further deterioration in the sovereign crisis might raise significant challenges, both on the valuation of banks' holdings of sovereign debt and through sharp changes in investors' risk appetite," it said. 

It also warned that "funding pressures" could "further affect market confidence in these banks" if not dealt with quickly. 

This blog has documented these "funding pressures" as the on-going run on the bank for both deposits and inter-bank loans.

... Tomorrow is the first chance for investors to give their view on the tests. Many observers are expecting a volatile trading session as the markets assess the findings of the exercise.

Bailouts are for buying time, disclosure is for restoring functioning capital markets

The Telegraph ran a column asking the question of whether more bailouts is really the right solution for the European sovereign debt crisis.

This is a trick question because everyone knows that all bailouts do is buy time.  By themselves, bailouts do not solve any problems.

For example, putting more capital into large US banks did not cause the losses on their toxic security holdings or second mortgages to go away - that was achieved through suspension of mark-to-market accounting and adoption of extend and pretend regulatory forbearance.  In theory, bankers could have realized their losses using the bailout capital.  In practice, bankers preferred to return the bailout funds and resume paying themselves large bonuses even though the losses still remain on their bank balance sheets.

The real question is how is that time purchased by the bailout going to be used to cure the underlying intertwined problems of sovereign debt and bank solvency.

Your humble blogger has proposed using that time to implement disclosure under the FDR Framework to restore functioning capital markets.

In the light of the deepening eurozone crisis and concerns over the implications of the EU bank stress tests, many commentators are now saying that the EU sovereign debt bailout fund needs to be perhaps five times as big, and that governments must declare themselves willing to recapitalise any insolvent or capital-inadequate banks as soon as next week. 

Really? You really think that the lesson of the past four years, since the financial crisis began in mid-2007, has been that governments have just not been sufficiently willing to stand behind the banks? That the problem with the eurozone is that governments that aren’t broke haven’t been willing to lend enough to those that are? That the poor impoverished bondholders in banks and sovereign debt have just been exposed to totally unreasonable levels of credit risk? 

... But surely anyone can see now that this has been a Failed Strategy  Surely anyone can see that the answer, from here, just can’t be for governments to become even more committed to their banking sectors, and bank bondholders even more shielded from any risk of loss? Surely anyone can see that the answer can’t be to move banking sector losses from poorer governments’ balance sheets onto richer governments’? Someone has to be left that isn’t broke! 

... This is a Failed Strategy. I understand perfectly well the political attractions of Denial, that governments in 2007 and 2008 wanted to pretend that nothing was really wrong, that it was all evil speculators or irrationally pessimistic markets, and if they could just bluff it out then the markets would understand that they’d got it wrong. Even if markets had been wrong (and they do get these things wrong sometimes), I wouldn’t have agreed that the government should pursue Denial – were governments truly in a position of such omniscience that they could declare, arrogantly, that the markets were wrong? And was the cost – the destruction of Private Capitalism, a system in which capital was allocated through private banks with depositors and bondholders subject to risk of loss - really worth it? In practice the government’s strategy was immoral – involving bailing out the richest 20 percent of the population (those with large deposits, those with large pension pots invested in the banking sector) at the expense of taxing the poor. 

Since I regarded the strategy as arrogant, destructive of our economic order (Private Capitalism) and immoral, I would have objected to it even if it had “worked” in its own terms.  But it didn’t.  Surely – surely – it’s time to try something else?

European Banking Authority deserves our thanks

I would like to take this opportunity to thank the European Banking Authority for reminding governments and financial regulators around the world about what restores confidence in the capital markets.

It is not regulators disclosing the results of stress tests.

Rather, it is disclosure of all the useful, relevant information in an appropriate, timely manner so that market participants can analyze this data and adjust the pricing and amount of their exposures based on risk.

While the disclosure of data that accompanied the stress tests fails to meet either the "all the useful, relevant information" or "in an appropriate, timely manner" criteria, it was dramatically better than the black hole of opacity that previously existed.

As reported in an article in the Telegraph,

... [T]he EBA and the European Union are under the impression that their power to pass and fail banks will translate directly into making them better at what they do. 

The fallacy of this approach is ... obvious... 

Namely that the regulators are setting themselves up for losing their credibility if the results of the stress tests can be discredited.  It is a no win situation for regulators.

Your humble blogger has repeatedly recommended that regulators should disclose the data and then survey market participants to see what the market participants think.  The regulators should then compare what market participants think and see if and why this differs from what the regulators' own analysis shows.

Take one of the more pertinent “stressed” assumptions the European authorities have used to test the 90 banks in the latest tests. 

Greek bonds are currently trading in the market at half their face value, yet the EBA seriously asks sophisticated investors to believe that they have properly tested the banks by applying a “haircut” of just 15pc to Greek debt. 

Or look at the €2.5bn (£2.2bn) of new capital the EBA says the eight banks that failed the tests will have to raise. 

Analysts at Credit Suisse, just three hours and 25 minutes after the EBA announced its results, have concluded that the actual amount needed would be more like €45bn and that 14 banks should have failed.  

The following part of the article is a description of the FDR Framework in action.  The EBA has provided disclosure and market participants are responding by analyzing this disclosure with the intent of adjusting the price and amount of their exposure to different European banks based on the riskiness of the individual banks.

As you read this, across the City and in financial centres around the world, groups of analysts at investment banks, hedge funds, pension funds, large companies and a host of other institutions are examining in detail the EBA numbers and conducting their own stress tests.  

They are likely to conclude that many European banks are in far worse shape than the authorities would like to believe. 

“Pass” or “fail”, the money men will make up their own minds about which banks are solid and which are not. 

Under their control are the purse strings every bank, large or small, requires to keep their doors open. 

Lose the faith of the funding markets and your days are numbered – as Lehman Brothers and Royal Bank of Scotland can attest. 

Some banks and their regulators may like to believe ... that the authorities’ stamp of approval is all they need to stay on the road. The financial markets are likely to take a different view. 

This week the markets will deliver their verdict on what they think the stress tests meant. They may, like Mr Enria, believe they were “rigorous”, “robust” and all those other fine words he used to describe them. 

More likely, Monday could see the beginning of a process that will deliver a much more real and painful test of the European banking system, one that will prove far more testing than anything the EBA chose, or was allowed, to inflict. 

Why the 2009 US stress tests worked

This blog has frequently observed that the reason why the US stress tests worked in 2009 was because the 19 banks that were tested were then backed by a pledge to inject as much capital as necessary by the US government.

Today, a Wall Street Journal article independently confirmed that it was the pledge to inject capital by the US that accounts for why the 2009 US stress tests were successful.

On Feb. 10, 2009, Treasury Secretary Timothy Geithner outlined the new administration's plan to subject 19 large U.S. banks to government-administered "stress tests" to see how much more capital they would need to fill the hole in the event of another severe recession or collapse of housing prices. 

The speech flopped. The Dow Jones Industrial Average lost nearly 400 points while he was speaking. The very phrase "stress test," though common in financial circles, conjured up images of Citigroup Inc. collapsing on a treadmill. The left derided stress tests as a poor substitute for nationalizing banks, the right as a precursor to nationalization, financial pundits as a whitewash or worse. 

Yet by most retrospective accounts, the stress tests worked better than hoped. Despite sniping that the worst-case scenario used wasn't bad enough, the tests were credible enough to help markets distinguish between weak and strong U.S. banks and to bolster investor confidence in the stability of the U.S. banking system. 

"The U.S. stress tests were a key driver of the recovery from the financial crisis both because they made bank balance sheets more transparent but also because they forced banks to recapitalize, with some government help," says Frederic Mishkin, a Columbia Graduate School of Business economist and former Federal Reserve governor... 

When results were disclosed in May 2009, after much speculation and back and forth between banks and regulators, 10 banks were told to raise $75 billion in new capital. The U.S. government had said taxpayers would provide capital from the Troubled Asset Relief Program unless banks could raise money from markets; all but one raised the money privately. 

Regular stress tests are now among the tools the Federal Reserve and other bank regulators are using to try to prevent a repeat of the financial crisis...

"The U.S. stress tests succeeded because they forced banks to raise a lot of capital," says Anil Kashyap, an economist at the University of Chicago Booth School of Business, noting the U.S. government's willingness to provide a "backstop"' source of capital if needed. 

"The last European test failed because it did not mandate recapitalization. Whether this one succeeds will hinge on whether they are honest about the capital shortages and include a backstop that will force the banks to raise capital one way or another."

Analysts begin the process of analyzing disclosure included with European stress tests

A UK Guardian blog on the release of the European stress test results documents the observation that analysts are interested in and fully capable of changing raw data into information.

3:20 pm

But Sony Kapoor, MD of Re-Define, an economic think tank, says the unprecedented level of detail contained in the stress tests will be a "real punch" that'll lead to a roller coaster few days.

"The EBA has done everyone a big favour by shining the light of transparency on opaque risks in the European banking system."

"The next few days are likely to deliver a roller coaster ride as the new information contained in the stress tests is digested and everyone waits for EU policy makers to make up their mind on Greece."

"The bank-sovereign links that the stress tests reveal means that the pressure to sort out the Euro crisis and put in place a good bank resolution framework will increase sharply."

5:00 pm data is released

5.24pm: FT Alphaville is updating the capital shortfalls as we speak [and making them available to all market participants.]

The run on European banks picks up steam

As predicted several months ago under the FDR Framework and subsequently chronicled, as confidence in European banks and European sovereign debt evaporates, the European banks are experiencing a bank run.

Just like in 2007, the leading edge of this bank run is interbank lending.  Just like in 2007, the lack of disclosure of current asset and liability-level data makes it impossible for banks to determine which of their competitors is solvent and which are not solvent.  As a result, banks stop lending to each other.

The Financial Times ran an article that shows that interbank lending bank runs are spreading across Europe.

Europe’s debt crisis has stoked tension in its interbank lending markets as some financial institutions find it harder to raise money ahead of bank stress tests due on Friday. 

UniCredit and Intesa Sanpaolo, Italy’s two biggest commercial banks, have been asked to pay higher premiums for lending, according to brokers, as the crisis has hit Italian government bonds amid growing fears of contagion. 

One broker said: “Lending is now very name specific. Banks will only lend to high-quality banks or names. Italian banks, in particular, have had difficulties this week. They can only access the markets if they pay big premiums. Other banks will not lend to them unless they pay up.” 

David Owen, chief European financial economist at Jefferies, said: “This eurozone crisis is a banking crisis as much as anything. Confidence among the banks has been undermined by Italy’s problems and there is a fear the stress tests will reveal problems.” 

The key measure of credit risk for short-term bank lending has jumped sharply since the start of the month. The spread between the risk-free cost to lend overnight in euros measured by Eonia and the cost to lend for three months measured by Euribor has jumped to 29 basis points from 20bp on June 30, a rise of 45 per cent... 

The jitters have caused problems for banks’ longer-term borrowing too. In the past six weeks, European banks have sold $19.1bn of senior unsecured debt – less than a third of the average $68.2bn they sold in the past five years during this period, according to data from Dealogic. 

Senior unsecured bonds form the biggest chunk of any bank’s financing efforts. But even sales of covered bonds, the loan-backed deals popular with investors who consider them ultra-safe, have slowed. Banks have sold $27.7bn in the past six weeks, compared with an average of $42.6bn for this period. 

More clarity needed on bank exposures

A Wall Street Journal Heard on the Street column called for investors receiving more clarity on US bank exposures to both financial institutions in and sovereign debt from Portugal, Ireland, Italy Greece, Spain and the US.

The column explicitly observes that without this disclosure, investors are going to assume the worse and require a higher rate of return to compensate for risk (as reflected in a lower stock price).

Banks are the last place to be in a financial storm. So it's up to big bank CEOs to assure investors their firms won't be swamped by crises brewing on both sides of the Atlantic....

But to be meaningful, they need to go beyond the usual generalities related to risk exposures...

Mr. Dimon previously has tried to put a figure on a European calamity. Writing in his annual letter to shareholders, he said in a worst-case scenario involving the so-called Piigs—Portugal, Ireland, Italy, Greece and Spain—J.P. Morgan "could lose approximately $3 billion, after tax." 

That figure needs updating. But Mr. Dimon shouldn't stop there. 

Any European banking problems likely will hurt Germany and France, where J.P. Morgan at the end of 2010 had total exposure of about $300 billion. J.P. Morgan should factor that into any update, as well as give more timely country exposure disclosures; it does so only annually. 

Citigroup and Bank of America, which report results Friday and Tuesday, respectively, provide quarterly updates. Yet they, too, need to put more flesh on their risk bones, especially Citi. 

The bank didn't report any sizable Piigs exposure at the end of the first quarter, while total exposure to France and Germany was $163 billion. But it did have the highest level of foreign government-bond holdings relative to its tangible common equity, at 139%. J.P. Morgan's was 91% and BofA was at 36%. 

And the banks shouldn't stop at Europe. The U.S. is a potential danger, too, with Moody's on Wednesday placing the country's top-notch rating on review for possible downgrade. 

Bank of America at the end of the first quarter had the largest holding of Treasurys relative to tangible equity, at 83%, with Citigroup following at 52% and J.P. Morgan at 29%. Those exposures should be manageable because it is unlikely government bonds would suffer more than temporary losses in a default over the debt-ceiling standoff. 

Again, though, investors need more information. 

Banks may be wary of getting too specific, ... But if investors are left in the dark, bank stocks will pay the price.

European bank run continues

The Irish Times ran an article on Europe's on-going bank run.

The bank run is a predictable reaction given the lack of disclosure.  When market participants do not know who is solvent and who is insolvent, it makes sense for them to withdraw their funds and find alternative investments to bank deposits or sovereign debt securities.

A Europe-wide test of the safety of its banks risks becoming a sideshow as long as politicians struggle to contain the continent's debt crisis and the detrimental impact on day-to-day funding for lenders. 

Bankers say rapidly rising funding costs are a far bigger headache than Friday's release of the results of the annual probe by the European Union's banking watchdog, which is running the rule over 91 banks to see if they have sufficient capital. 

"The collapse of market confidence in sovereign debt affects banks more than any regulatory stress test," said an investment banker who advises financial institutions. 

"This is the markets stress-testing the system, which is far more dangerous than any simulation by a regulator." 

Lack of clarity about how Europe plans to tackle the risk that countries such as Greece will default under a huge debt burden has sent bond yields soaring, dramatically raising the cost for banks when issuing new bonds. 

The drop in bond values also means banks may need to write down any portfolios of sovereign bonds they hold. Bank shares have been losing ground as a result. 

Depositor funding - from clients who put their money in a current or a savings account - is also under pressure, with withdrawals seen in countries such as Ireland and Greece and a fight for deposits in Spain and elsewhere squeezing margins. 

And other funding channels - such as the covered bond market, commercial paper, or asset-backed securities - are also starting to look increasingly shaky. 

"Look at what's happening in Italy. The rates are going up 30 to 40 basis points a day. 

That's going to translate into a higher cost of funding," said a second investment banker, whose clients are also financial institutions....

European finance ministers have acknowledged for the first time that some form of Greek default may be needed to cut Athens's debt, but investors fear that could ripple through Europe's banking system. 

European banks have raised about €43 billion since their resilience against economic headwinds was tested last year, and this year will show the need for more capital. 

This year isn't expected to throw up any surprises, either in terms of the numbers or the likely test failures. 

A survey by Morgan Stanley in April estimated that fewer than 10 banks would fail the test, and that €30 to €40 billion of capital would be raised in the run-up to or after the exercise. 

Unlisted banks in Spain and Germany and a batch of banks that are already raising new funds are the most likely to fail this year's tests, analysts at Nomura have said. 

"These are well identified today; there are some cajas in Spain, there are couple of regional banks. It's a very well-known sample of banks," the second banker said. 

Nomura identified Spain's Bankinter and Sabadell, Italy's Banco Popolare; Greece's Piraeus and ATEbank; Cyprus-based Marfin Popular and Bank of Cyprus; and Bank of Ireland and Allied Irish Banks as vulnerable. 

The EBA is also conducting a liquidity assessment, but its results will not be published. It is conducted in parallel with the stress test, and is used to inform supervisors about areas of funding vulnerability. 

Given the uncertainty, the two bankers were telling their clients to hunker down.