Following publication of the European Banking Authority (EBA) stress test results in July 2016, the German Centre for European Economic Research, ZEW, has published an alternative test of the banks in question, concluding that capital shortfalls are significantly larger than suggested.
The research, jointly conducted by Viral Acharya, Diane Pierret and Sascha Steffen, flagged up inconsistencies in the EBA’s methodology, with the 2016 criteria being less stringent than those applied during the previous stress test in 2014. The ZEW research also subjected banks to the more stringent criteria applied by US supervisors in the Comprehensive Capital Analysis and Review (CCAR).
The most recent EBA stress test was conducted on 51 banks representing 70% of European bank assets, while the 2014 test surveyed 123 banks. Just as in the 2014 asset quality review, the 2016 stress test used the CET1 (Common Equity Tier 1) ratio as its target capital ratio, using a baseline ZEW Institute challenges EBA stress tests
scenario of 8% and an adverse scenario of 5.5%.
However, in contrast to 2014, it did not specify a benchmark capital ratio and threshold for banks to either pass or fail the test. Moreover, in contrast to earlier stress tests, the focus of the 2016 EBA research was not to identify urgent capital weaknesses, but rather to provide information regarding an adverse scenario.
In contrast, the ZEW research used the different supervisory approaches applied by the EBA in 2014 and the CCAR in order to translate the lossesfound in the 2016 stress test into actual capital requirements.
While the 2014 test concluded that 25 lenders had failed to match the criteria, the results of the 2016 EBA survey were overwhelmingly positive, concluding that banks had overall increased their CET1 ratio since 2014. Per definition, no bank could fail the test.
The ZEW research sketches a more critical picture. Applying the EBA’s own 2014 criteria, the methodology used by US supervisors in the CCAR and a market-based approach, the research flags up that capital shortfalls could well be significantly higher than anticipated.
Using US CCAR rules including a 4% Minimum Tier 1 Leverage Ratio, ZEW concludes that total capital shortfalls among the 51 banks surveyed amounted to €123bn, rather than the €5.6bn shortfall found in the EBA test.
Further, while the 2016 EBA stress test only highlighted capital shortfalls of Italy’s Banca Monte dei Paschi di Siena, the methodology applied by the ZEW research flagged up Deutsche Bank, Societe Generale and BNP Paribas as some of the most vulnerable lenders, with capital shortfalls of €19bn, €13bn and €10bn respectively.
The results are even more pronouncedwhen forecasting potential capital shortfalls using a market based approach –based on market equity rather than book equity –in order to determine leverage. Using data for the 34 publically listed banks alone, total capital shortfalls amount to €640bn, compared to €92bn according to the CCAR methodology.
On a per country basis, capital shortfalls using the CCAR methodology appear to be particularly severe in Germany (€24bn), France (€23bn) and Italy (€18bn), with France, the UK, Germany, Spain and Italy accounting for 90% of all potential capital shortfalls.
“Our results suggest that the European banking sector requires a comprehensive recapitalisation across almost all countries, including Germany,” says Sascha Steffen. He adds that results also suggest that capital shortfalls revealed in the ECB assessment of 2014 have not yet been dealt with. Those banks that had large shortfalls two years ago still have capital shortSource ZEW falls today.”
Viral Acharya is professor of Finance at New York Stern University School of Business, Diane Pierret is assistant professor Banking and Finance at the University of Lausanne and Sascha Steffen is professor of Finance at the University of Mannheim and head of the ZEW Research Department “International Finance and Financial Management”.