Stress Test

The streets were deserted below, as you would expect on a Sunday evening in the City of London. Yet 18 floors above Old Bond Street the lights were burning bright. An indication that some kind of activity was taking place approximately 50 meters above the urban walkways.

The entire 18th floor is home to the European Banking Authority (EBA), which was established in January 2011 in the wake of the financial crisis. The aim of the EBA, in a nut shell, is to prevent another financial crisis occurring by drafting up and enforcing a set of banking rules to ensure the European banking system is fully capitalised. The EBA is a super authority, in that it’s above national regulators. So in the UK's case it presides over the Bank of England. Another opaque organisation also falls with the EBA's jurisdiction, known as Committee of European Banking Supervisors.

EBA's latests stress test on European banks was due out on Sunday, October 26. The idea was to simulate a worse case scenario for the European economy and test whether the banks would be robust enough to withstand the shock.

European Banks were tested on their ability to withstand a 5 percent contraction in European Union (EU) Gross Domestic Product (GDP) by 2016 and a sharp rise in EU unemployment, which shot up to around 13 percent from its current level of 10.1 percent. And of course a bond market crash was thrown into the “doom” equation.

Based on the EBA's simulation, as outlined above, one in five European banks were deemed to be under capitalised and likely to run into trouble, should the EBA's conditions of a worse case scenario become a reality.

British banks performed the best in the stress tests, being the most resilient in Europe and able to withstand the greatest losses and still retain sufficient capital buffers to survive a future financial shock. The EBA calculated that HSBC could weather 43 billion pounds sterling of losses on its banking and trading books over the next three years and still have sufficient capital buffers. RBS, Lloyds and Barclays were judged to be able to withstand losses amounting to around 25 billion pounds sterling. Lloyds was left with the weakest capital position. Under the adverse scenario, the EBA said its capital base would be eroded to 6.2pc, from a starting point of 10.2pc. Nevertheless, a Lloyds spokesman welcomed the results of the test. "This strong position reflects the steps taken by the group's management over the last three years to return its balance sheet to a robust position, and we will continue to use this strong basis to help Britain prosper”, said the spokesman.

“UK banks have significantly built up their equity levels post the crisis after leverage was unearthed as a fundamental flaw with European banks as compared to their US peers”, said Chirantan Barua, an analyst at Bernstein Research. “In fact all the banks today hold the highest level of capital that they have ever carried in 20 years.”

On the other end of the performance scale, Italian Banks have been the hardest hit by the ongoing crisis in the Eurozone. Banca Monte dei Paschi di Siena, the world’s oldest bank,was just one of 25 European bank that failed the EBA latest stress test and needs to recapitalise by 2.1 billion pounds, if it is to weather a storm. The Italian bank has hired UBS and Citigroup to explore its options as the bank considers how to plug the capital hole. “Italian banks need to address their capital shortfalls by forgoing dividend payouts, selling assets and cutting costs even considering some consolidation across the sector”, said Raj Badiani at IHS Global Insight.

Portuguese lender Banco Comercial Portugues also failed the stress test. However, its spokesman claimed that it had raised 2.24 billion pounds sterling of Tier 1 eligible capital by the end of September, which would be enough to cover a 1.14 billion pounds sterling shortfall based on last year’s accounts. A number of Greek banks also failed the stress test.

Below is a complete list of the 25 European banks that were deemed to be under-capitalised to withstand a future financial shock

Eurobank

Monte dei Paschi di Siena

National Bank of Greece

Banca Carige

Cooperative Central Bank

Banco Comercial Português

Bank of Cyprus

Oesterreichischer Volksbanken-Verbund

permanent tsb

Veneto Banca

Banco Popolare

Banca Popolare di Milano

Banca Popolare di Vicenza

Piraeus Bank

Credito Valtellinese

Dexia

Banca Popolare di Sondrio

Hellenic Bank

Münchener Hypothekenbank

AXA Bank Europe

C.R.H. - Caisse de Refinancement de l’Habitat

Banca Popolare dell'Emilia Romagna

Nova Ljubljanska banka

Liberbank

Nova Kreditna Banka Maribor

Commenting on the results, ECB Vice President Vitor Constancio said, “Out of the 25, 12 banks have already taken measures in 2014 that are enough to cover their shortfall.”

While the results are intended to bolster confidence in the European banking system there is some question as to how successful that will actually be.

Playing devils advocate, the worse case scenario simulated by the ECB looks more like the best case scenario. EU unemployed 13 percent and GDP contraction 5 percent, that is assuming a financial crisis similar to 2008 with the economic fallout that ensued. But the policies pursued by the central banks, of loose monetary policy, did little or nothing to eradicate the causes of the last crisis. In fact, it might have created a bigger bubble, a larger wealth gap and a skeptical population. If the pending crash is going to be bigger, then the ECB test results are irrelevant.

Secondly, national supervisors were engaged in their own stress tests. In other words, they were their own judge and jury, and that makes the results of the test biased.

The EBA's previous stress test in 2011 was criticised for being too soft and not taking into account the possibility of a sovereign default.

So could the latest EBA stress test be just lipstick on a pig?