The deadline has been deliberately chosen: At 10 p.m. Central European Time on Friday night, after the close of financial markets in the United States, Europe’s top regulators will release the results of their latest round of stress tests, designed to gauge the health of the continent’s embattled banking sector.
The tests are being conducted by the European Banking Authority (EBA) and the European Central Bank into the balance sheets of 51 top banks across the 28-nation European Union. The idea is to test the health of banks against an imagined crisis scenario spread over the next three years and see how they hold up.
The test comes at a time when banking stocks have been taking major hits across the board in Europe, and especially in Italy. That’s part of the reason the results are being released late — giving investors two full days to digest the results before markets open again on Monday.
Adam Farkas has a busy few days ahead of him. The head of the EBA spoke to Handelsblatt shortly before the big release. In the interview below, Mr. Farkas defends the EBA against accusations that it has gone soft this time around. Unlike the last round of stress tests in 2014, no bank will actually pass or fail this time around. In Germany, there is also criticism that regulators aren’t looking at the effects of negative interest rates.
Mr. Farkas insists the lack of a pass/fail grade is deliberate, and doesn’t mean supervisors won’t be holding banks’ feet to the fire. Some banks may even face new capital requirements as a result of the test. But for most, he argues, Europe’s banking troubles have turned from an acute crisis into a slow-burning challenge of how to remain profitable over the long haul.
Overall, he says, the European banking crisis is only half-solved.
Handelsblatt: Mr. Farkas, the design of the stress test is attracting a lot of criticism even before the publication of the results. What use is a stress test if topics such as as negative interest rates are not included in the scenarios?
Adam Farkas: The stress test scenario is not designed to model any specific event or any specific one-off development. It is designed to test a general macroeconomic scenario, which represents a serious downturn over a period of three years. It is less important what triggers the shock than what effect it has. The scenario developed by the ESRB represents a significant shock on banks’ profit-and-loss statements and balance sheets. You will see from the result that it has a very significant impact on the capital ratios.
“It is correct that no bank will fail. On the other hand no bank will pass either. I think we have to get on with cleaning the banking system of non-performing assets and restore ability to generate profit.”
But what about the negative interest rates that Europe is facing? They seem to be more than a one-off problem.
The impact of the [stress test] scenario causes a significant funding shock and a significant movement of the profitability of the banks. If you compare this scenario in terms of the size of the impact with the negative interest rates scenario, it is quite comparable. Modeling a specific negative interest rate scenario wouldn’t have been more relevant in terms of the impact on the banks.
So what you are saying is that modeling a severe economic downturn can indirectly give you an idea of the effect negative interest rates can have on banks?
Of course there are different impacts of negative interest rates compared to an interest-rate shock or a sudden increase of interest rates, which we have included in the stress test. But the overall economic impact would be rather similar.
The stress test seems to forecast a more severe economic downturn for Germany than for Italy. How realistic is that?
Over the three-year period of the test, they are quite comparable. The main difference is the speed at which the downturn builds. The ESRB looked at the possible [economic] evolution based on the run-up to the stress test period.
A recession is not the only danger banks are facing. Market risk is another example. Is the stress test blind to these risks?
Certainly not! We check severe market shocks in the tests. In recent weeks we saw very significant market movements in the currency markets and in the equity markets…
…for example during the Brexit vote in Britain…
These are movements which clearly represent an increased level of volatility and an increased level of market risk. But they were far below the scenario which is used in the stress test.
But what really seem to be missing from the stress test sample are banks from smaller jurisdictions, like Portugal. As the fate of banks and their home countries remain closely linked, this seems strange.
The EBA chose a sample of banks which represents a large part of the European Union’s banking system. But if a specific bank is missing in our sample, it doesn’t mean that no supervisor has been looking at it. Supervisors are in many cases undertaking similar exercises with banks not included in the EBA list.
Unlike earlier stress tests, this will not be a pass-or-fail-exercise. Doesn’t that mean it has lost relevance?
I would strongly dispute this. The objective and the role of the stress test are changing. At the early stage of the crisis there was a clear need for robust supervisory action to recapitalize banks, to inject significant amounts of capital into practically the entire European banking system. At that time, in 2011, the role of the stress test was an analytical tool to assess the overall need and to break down this need to bank-by-bank capital requirements. Since that time, the capital ratios of banks have increased by an average of 4 percentage points. The next step to repair the banking sector was to assess the asset quality of the banking system. That was the objective of the exercise in 2014.
So what is the role of this year’s exercise?
Now the stress test is being used as an important supervisory tool to do the pillar 2 assessment…
…that’s what you call the process by which supervisors will set additional individual capital requirements for every bank, according to their individual risk situation…
…and to support the supervisors’ efforts to clean up what they found in the asset-quality reviews. It can be used by some banks to push for further recapitalization. But in most of the cases, it will be used to provide capital guidance.
But the outcome will influence only the capital guidance by supervisors for banks, which is not mandatory. So what relevance does the stress test have?
In some cases the results will also be part of [capital] requirements. But in most cases, for banks in a business-as-usual situation, it indeed serves only as input to establish a capital guidance, which provides a cushion for unexpected but plausible events in the future.
You say the banking system has become more robust but share prices and valuations show that deep mistrust of European banks remains among investors. Wouldn’t a pass-and-fail-exercise have increased the chances of rebuilding trust?
You are right, the valuations are not encouraging. But I did not imply that the European banking system has finished the process of repair. We are clearly not at the end of the road yet. What we have overcome is the need to massively recapitalize the entire European banking system across the board. We also identified vulnerabilities in the balance sheets. Now we are imposing a severe shock on the banks. It is correct that no bank will fail. On the other hand no bank will pass either. I think we have to get on with cleaning the banking system of non-performing assets and restore their ability to generate profit and capital. That takes some time and hopefully then also the valuation will improve.
If the banking system was a four-room apartment, how many rooms would we have cleaned so far?
I think we are in the middle of that process. There is a very strong policy consensus that action has to take place. In some corners of Europe the problems have been resolved to a large extent, in some other parts more has to be done. So, all in all, we might have cleaned the second room.