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Tested and found wanting

27 October 2014 By George Hay

Investors are turning their noses up at the European bank stress tests. Shares in the sector fell 1.9 percent on average on the morning after publication, with both banks that passed and those that failed being targeted. That’s because a clean bill of health on the test’s headline terms does not necessarily mean a lender has enough capital over the medium term.

Take Raiffeisen. The Austrian group was seen as a winner and was one of the few banks whose shares rose on Oct. 27. The test shows a 7.8 percent ratio of “core Tier 1” equity to assets, after three years of stress to its balance sheet. On first glance that looks pretty healthy.

However, this is using the less rigorous “transitional” version of Basel III capital regulations, which gradually phases out phony capital such as deferred tax assets and goodwill. Raiffeisen’s ratio falls to a skimpy 3.9 percent on the tougher “fully-loaded” version of Basel III after the same adverse stress.

On this metric, 34 of the 123 lenders tested would have failed, instead of 25. The focus on transitional measures, while allowed by European regulations, is rather complacent. At least the stress test, and the accompanying asset quality review, which harmonises bad debt calculations, allows the market to see who is underpowered on the tougher version of Basel III. The list includes four German and nine Italian banks.

To make things worse, the exercise has a curious blind spot. The nastiest scenario assumes a sharp contraction in economic output but doesn’t assume that the euro zone as a whole enters deflation. This is now a distinct possibility. If prices do start falling across the currency bloc, customers would find it harder to pay off their debts and bank losses would spiral.

All told, investors should not allow banks to relax now they have passed. Instead shareholders should use the greater disclosure as a stick to beat management into raising capital. That applies as much to banks who have seen a pleasing bump to their share price today as to those who haven’t.




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