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Source: riskdynamics.eu

The United States have learned from their bad experiences during the Global Financial Crisis wherein almost its entire financial system was going down in flames. Stress tests to find out how banks would be able to deal with economic adverse scenarios became mandatory, and the European Union followed suit with its stress tests in 2011, followed by a series of check-ups later on.


Source: Daily Mail

Almost a decade has passed since the GFC, and half a decade since the European stress tests, but the volatility and unrest in the financial world has never been this high. You would think that five years of ECB-supported lending would have helped these banks (as even though the net interest spreads did decrease, the access to the ultra-cheap lending facilities of the ECB allowed the banks to continue to generate positive results), nothing has changed, and more than 5 years after the term ‘PIIGS’ became one of the most well-known words to describe the economic mess in the weaker European, one of the I’s is now once again in serious economic trouble.


Source: Financial Times

The Bank of Italy has now publicly stated some of its banks will need more state support to merely stay alive as the position of these banks has been deteriorating since the Brexit vote. Some of the smaller ones have been forced to merge with each other to create larger companies which should theoretically be able to withstand economic shocks.

One would have expected the stress test of the ECB (with new results anticipated to be released at the end of this month), which was indeed focusing on how banks would deal with adverse economic scenario’s, and more importantly, how their capital ratios and balance sheets would hold up, would have taken care of the majority of these risks. After all, the banks had almost 5 years to hoard cash (by retaining their normal earnings) and to tap the market on opportunistic moments.

Banco Popolare is one of those banks which have been forced to merge with another company after the capital ratios were unsatisfactory. The bank has now raised 1B EUR in what seems to be an emergency capital raise. After all, the new shares were priced at 2.14 EUR, or approximately 50% lower than the share price before the announcement and even though it’s great to see a bank is able to raise cash, one really has to start to question these measures. But what’s even more scary is the fact the bank is now targeting a non-performing loan ratio of 18% by 2019, down from almost 25% in 2015. That’s right, the non-performing loan ratio was shockingly high at almost 25%…


Source: Bloomberg

Banco Popolare was trading at in excess of 10 EUR less than a year ago, so why does the bank now have to complete an emergency capital raise? It’s definitely looking like the regulators were asleep at the wheel, as a capital raise right after the summer of last year would have been much more advantageous for this specific bank, reducing the dilution to just 20%  (instead of 120% now) to raise the same amount of money. Yes, the net income from the banks all over the Eurozone will be negatively impacted, but it’s pretty clear either nobody saw this coming, or nobody wanted to spoil the party that was going on on the financial markets last year.

This strengthens the thesis the ECB has used the wrong approach to stress test its financial system. Whereas the ECB used a top-down approach by checking how news macro-economic circumstances would impact the capital ratio of a bank, it would have made much more sense to use the SRISK method, developed by Acharya, Engle and Pierret, professors at the NYU Stern School of Business and the University of Louvain-la-Neuve.

The SRISK method uses a different approach, as it recalculates how much a bank would need to raise to maintain its capital ratios during worse economic times, and that might be more important to know than by how much the capital ratios will drop (after all, if these ratios drop, the banks will need to restore them rather than just ‘waiting’ for the economic headwinds to disappear). And this SRISK method tells you a completely different story, a story the ECB wouldn’t really want you to know, as it has been buried deep inside a working paper which discusses what the impact would be on the banks should the stock market fall by 40%.


Source: ECB working paper

As you can see, under the SRISK method, several large banks will be more severely impacted compared to the ‘official’ stress test results of the ECB. The impact under the SRISK method will be more than 4 times higher for Banco Santander, BBVA, and ING than it would be under the ECB’s calculation method.

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First published here: http://j.mp/29pK87u