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Will ECB's cheap loans help euro banks survive 2014 stress tests?

February 17, 2014



Euro-area lenders are bracing for the 2014 European-Union-wide stress tests under the umbrella of the European Central Bank (ECB)'s new banking supervision in coordination with the European Banking Authority (EBA). Three year ago, the EBA carried out the last formal EU stress tests, which were criticized for failing to detect the problems at the debt-traumatized banks. In 2013, the EU's top banking regulator delayed stress tests until the ECB claims its supervisory powers and likely use stricter rules than it will to study the lenders' assets in 2014. But was the cushion of liquidity provided by the central bank enough for the euro-area's top lenders to survive this year's check-up? In this topic, we will review the silver lining the ECB has offered the bloc ahead of its forthcoming banking health checks, so let's get started by defining what is this exercise, and how far the ECB could go to prove it can spot weakness before it becomes the bloc's single bank supervisor this November. What is "stress testing"? A simulation technique used on asset and liability portfolios to determine their reactions to different financial situations, and especially times of crisis. Stress tests are also used to gauge how certain stressors will affect a company or industry. They are usually computer-generated simulation models that test hypothetical scenarios. The Monte Carlo simulation is one of the most widely methods of stress testing. Banking supervision? The ECB is poised to take on new banking supervision tasks as part of a single supervisory Mechanism, which will create a new system of financial supervision comprising the ECB and the national component authorities of participating EU countries. Among these EU countries are those whose currency is the euro and those whose currency is not the euro but who have decided to enter into close cooperation with the single supervisory mechanism. The main aims of the single supervisory mechanism will be to ensure the safety and soundness of the European banking system and to increase financial integration and stability in Europe, in other words, build confidence in the sector. In late 2012, the ECB was granted with new supervisory powers by the EBA to put 128 euro-area banks accounting for about 85% of the bloc's banking system though rigorous review it will conduct this year. It is expected that the ECB will assume its new supervisory powers in autumn 2014, particularly in November, one month after it concludes its assessment. The comprehensive review comprises three complementary pillars: - A supervisory risk assessment, addressing key risks in the banks' balance sheets, including liquidity, leverage and funding. - An asset quality review, examining the asset side of bank balance sheets as at December 2013. - A stress test, building on and complementing the asset quality review by providing a forward-looking view of banks' shock-absorption capacity under stress The ECB will ask banks in its balance sheet review for an 8% capital buffer. That could have been higher but may still prove a challenge to some banks as they attempt to become crisis-proof. "A single comprehensive assessment, uniformly applied to all significant banks, accounting for about 85% of the euro-area banking system, is an important step for Europe and for the future of the euro-area economy. Transparency will be its primary objective. We expect that this assessment will strengthen private sector confidence in the soundness of euro-area banks and in the quality of their balance sheets," ECB President Mario Draghi said. The EU-wide stress tests are a key milestone for the successful implementation of the European Banking Union . The results will offer a leeway for ECB on how to deal with failing banks in the euro area, the second stage in building a banking union. The European Union is battling to bolster the financial sector for the lenders to get back on their feet dependently, without relying on full-blown bailouts, so government will not be allowed to interfere if banks underperformed under any circumstances. More, the banking union will include a centralized system for the management of weak banks deposit insurance funds, all as part of a single supervisory mechanism by the ECB. The EBA will test the way top banks reviews the value of loans and other assets, making sure the results of its stress testing will turn better result this year than in 2011 – when eight banks failed the exams with a total shortfall 2.5 billion euros ($3.2 billion). Eight out of 90 banks across Europe have failed the fitness test, with a total shortfall 2.5 billion euro, a slight increase on seven last year. In other words, investors weren't persuaded that the EU is coming clean about the extent of its banks' problems. The 2011 EU-wide stress test had faced criticism in the past for being too lenient, and for not spotting the real problems in the some European countries, After which, Spain had to ask for a rescue fund directly for banks from international creditors, after Greece, Portugal, Ireland and Cyprus screamed for financial lifelines. Spain's troubled banking sector, which accounts for more than a quarter of the 90 European institutions tested by the EBA, takes center stage at the this year's stress testing, after the debt-laden nation received 100 billion euros in aid by the European Union and the International Monetary Fund (IMF). In 2012, the Spanish government nationalized the country's biggest mortgage lender, Bankia, but couldn't afford to rescue them all. So Europe stepped in, with about $60 billion euros in loans. A living example of good bank restructuring was Ireland, although it was the least lucky when it comes bailouts as its banks came close to collapse. In November 2010, the Irish government had to seek a 67 billion-euro bailout as part of an 85 billion-euro program. Why good bank restructuring? Ireland had successfully exited the bailout program in late 2013, becoming the first nation to do so since the euro area's debt crisis erupted, and now its storming stormed it way back into international bond markets. Will ECB's LTROs contribute in a successful bank stress-testing in 2014? The ECB started the biggest injection of credit into the European banking system since the introduction of the euro, in a bid to tackle the debt crisis, restore stability to the distressed financial sector and bolster economic activity across the 17-nation currency bloc. Long Term Refinancing Operations (LTROs) provide an infusion of low interest rate funding to euro-area banks with sovereign debt as collateral on the loans. The cheap loans are offered monthly, and are typically allotted in three months, six months and one year. But the ECB also announced a three-year LTRO in December 2011, where it loaned 489 billion to 523 banks for an exceptionally long period of three years at a rate of just 1% under its LTROS. In February 2012, it held a second auction, LTRO2, providing 800 euro-area banks with further 529.5 billion euros in cheap loans. The ECB's debut of three-year LTROs in December meant that this time scale was extended, which helped cause a much greater take-up than usual, after all the money was used to help government debt markets by encouraging a carry trade in high-yielding sovereign bonds and make profits, besides to unlocking credit for companies and households by giving small and medium-sized banks access to funding. Banks can use assets such as sovereign bonds as collateral for the loans, although they can no longer use Greece's bond and collateral after the country was downgraded to a default rating by Standard & Poor's. This has helped to boost some of the more distressed sovereign bonds, in peripheral countries such as Spain and Italy, as their yields have dropped sharply in the past two years because they are being used as collateral for the operations. Spanish and Italian banks were the most to obtain cheap funding through the ECB. The next table demonstrates the size of of ECB borrowing based on the countries who sought these cheap loans until November 2013: LTRO BY Countries  2013 2014 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Spain 246.6 229.0 225.7 209.8 315.3 320.0 329.1 316.1 Italy 262.0 244.4 234.0 224.9 276.6 269.7 272.6 268.3 Portugal 45.0 45.3 45.4 43.4 50.6 53.3 50.5 49.3 Greece 1.6 1.5 1.5 1.4 36.8 3.1 2.2 1.9 Ireland 44.4 37.3 35.4 35.2 79.0 77.0 67.0 63.1 France 119.3 95.4 89.1 71.2 144.3 169.1 172.6 174.4 Belgium 16.1 14.5 14.4 14.3 39.8 39.7 39.7 39.9 German 21.6 11.8 9.9 8.4 73.2 77.0 73.9 69.7 As we can clearly see, Spanish banks topped it euro-area counterparts by borrowing all they possibly could, particularly with Spain's government encouraging them to buy government paper. But as portions of the deposits came back and banks being able to sell some government papers, they are repaying some central bank borrowings. Though these LTROs, The Spanish government was able trim its festering debt, proven by the remarkable drop in the country's 10-year bond yields in the past two years as we can see in the chart below. To recap, banks have started to repay the two three-year LTRO tenders by the ECB last year from January 30 for the first tender and February 27 for the second. After these dates, borrowers are able to repay on a weekly basis, until the LTRO expiry in early 2015. ECB LTRO Repayments (the figures are in terms of billion euros) Actual Amount of LTRO 1 489.2 LTRO 1 Cumulative Repayment 225.4 Number of banks  543 LTRO 1 Outstanding 233.8 LTRO 1 Outstanding % Initial Allotment 47.8% Actual Amount of LTRO 2 529.5 LTRO 2 Cumulative Repayment 170.2 Number of banks  670 LTRO 2 Outstanding 359.3 LTRO 2 Cumulative Repayment 67.9% The previous table shows how banks tended to pace up repayment against the backdrop of clean up of their balance sheets before the upcoming checkup. They are getting in shape!  In fact, the repayments were almost four times largest than analysts had expected. As for the ECB's balance sheet, we can see that assets have declined during 2013 from a year ago, given the impact of early repayment of three-year tenders by the euro area banks as shown in table below, according to data published on 20 December, 2013. Total Assets (in Euro Billions) 2012 2013 3,018.2 2,283.0 LTRO repayment 1,128.8 614.4 Assets Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2964.4 3,102.2   3082.4 3018.2 2,430.4 2,430.4 2,338.0 2,283.0 LTRO 1,090.9 1,079.7 1,058.8 1,035.8 778.9 705.4 670.2 614.4 Obviously, assets declined to 2.28 trillion in the fourth quarter 2013 from a peak of 3.1 trillion euros a quarter ago, driven directly by the drop in long-term loan repayments during 2013 to level of 614.4 billion euros. Conclusion: The early repayment of cheap ECB loans, which has been granted to avoid a credit crunch, is more of a proof that euro-area banks are on track to recovery, and the next health checkup is more likely to reveal positive results than in 2011. But where did the banks go with rescue funds obtained through the crisis? A question worth pondering! To be continued…


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Source: ICN.com Financial Markets


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