European bank stress tests: A preview

- "We view the upcoming release of the European banks stress test results as a potentially important inflection point for the market. The experience in the US last year suggests that properly executed stress tests can greatly improve confidence in the stability of the financial system. In Europe, they may ease concerns by ensuring that the sovereign crisis and a likely slowdown in euro area growth will not result in widespread bank failures."
- "We have a bias to be long risk as the results of the stress tests are released. First, the capital needs we estimate are not insurmountable, particularly given the programs already in place to address them: FROB in Spain, the SoFFin in Germany, and the Financial Stability Fund in Greece. In each case, the total needs are within the potential scope of the programs. Even if some programs have difficulty funding, it is possible that the European Financial Stability Facility (EFSF) would provide a backstop, given the relatively small size of the needs. Second, although pessimism has retreated somewhat as markets have rallied over the past two weeks, many investors are still very sceptical of the stress tests, suggesting room for upside surprises. Finally, for the majority of banks, transparency alone may succeed in restoring confidence. Any market stabilization due to the stress tests would be beneficial to banks, particularly if it allowed them to issue term debt at lower spreads and move away from covered bonds and ECB funding that they have been forced to use recently."
- "To achieve this, the tests must: create transparency and/or stress balance sheets with respect to loans to corporates and individuals, as well as sovereigns; differentiate
between strong and weak banks using a sufficiently high minimum core T1 capital
hurdle; and force recapitalization of failing banks, with governments positioned to
backstop institutions that are unlisted/unable to raise capital privately."
- "In our view, the institutions most likely to “fail” the stress tests – meaning be forced to raise new capital – are Spanish cajas, German Landesbanks, and Greek banks. Based on some simple assumptions using the information available from the European regulatory authorities, supplemented with the methodology used in the US stress tests, we estimate capital needs of EUR36bn for Spanish cajas, EUR34bn for German Landesbanks, and EUR8.6bn for Greek banks. Importantly, these estimates are based on a number of assumptions and are designed more to compare the potential capital needs with the programs in place to address them than to predict the exact results of the tests."
- "There are admittedly a number of risks to a long bias going into the release of the
results. According to our estimates, FROB may have to issue EUR34bn. Although this
could be spread out over time, difficulties in issuing cannot be ruled out while Spain
itself remains under scrutiny. Regulators may fail to create the transparency needed or
to set sufficiently aggressive loss assumptions. Capital hurdles may be set too low by
looking at T1 capital instead of core T1 capital. Bank books may be treated too lightly.
Finally, spreads have rallied over the past two weeks, suggesting the bar is no longer set so low that any disclosure whatsoever will cause a rally."
Barclays Credit Research 20100714