Europe’s big banks are facing tough, credible stress tests that should help shore up investor confidence, according to Fitch Ratings.
In a report published today, Fitch says that the assumptions to be used in the European banks’ stress tests “appear sufficiently robust to bolster investor confidence”, particularly when coupled with the asset quality reviews that European regulators are also carrying out.
“The quantitative stress evaluation is a good first step in ensuring Europe’s major banks are adequately capitalised,” Fitch says. The ratings agency added that, “Reviews on capital planning, governance and contingency planning could further enhance confidence.”
Nevertheless, the rating agency suggests that the credibility of the EU-wide stress test will be enhanced this time around by the reviews of banks’ asset quality. It also sees these reviews as “a step towards the harmonization of asset quality measurement for the region, leveling the playing field for identifying problem loans and assessing reserve coverage.”
The stress test itself includes both baseline and adverse scenarios, and Fitch says that these tests are “more complex, comprehensive and tougher” than a recapitalisation exercise that was carried out in 2011.
“We see the bond yield shock component in the adverse scenario as particularly important for this review given the risk that a tapering of U.S. Federal Reserve bond purchases over the next year could leave some markets, particularly emerging market economies, vulnerable. Another important shock is a currency depreciation in central and eastern Europe to reflect global financial tensions,” it notes. Additionally, the inclusion of sovereign debt haircuts in the scenarios makes the test more rigorous, it says.
Fitch suggests that these tests could be further enhanced by the inclusion of a qualitative assessment, as U.S. regulators have done; which, it says, could boost investor confidence in risk management and governance of a bank’s capital planning process. “But we do not expect this to be introduced in Europe before this year’s round of stress tests is complete,” it says.
As for the time regulators will give the banks to cover the capital shortfalls revealed in the tests — six months for the baseline scenario and nine months under the adverse scenario, Fitch says that the nine month time horizon appears to be “fairly aggressive but probably necessary to ensure confidence in the process and establish European banks on a solid footing.”
In a separate report, Fitch also notes that the stress test scenarios that will be used by the Bank of England appear to be fairly tough as well, and that it “addresses sector risk stemming from households’ high indebtedness compared to the rest of the EU”.
“Banks’ vulnerability to house-price shocks and a sharp reversion to higher interest rates are particularly important components of the Bank of England’s test,” it notes. “The risk is particularly high in the UK because of the large proportion of mortgages extended at variable rate and high income multiples, prompted by the wide gap between house prices and earnings.”
Several big British banks — Barclays, HSBC, Lloyds and RBS — will participate in both the UK and EU stress test exercises, Fitch reports. The UK results will be published towards the end of the fourth quarter, after the EU-wide stress test results are released in October, it notes.
Fitch also points out that UK banks have raised about £7.6 billion in additional Tier 1 capital over the past year to boost their leverage ratios and be better positioned for the stress test process.