On Sunday there will be published the results of stress tests. According to the news agency Efe, 11 banks will be shot down by the ECB. Here are 5 possible scenarios for institutions at risk.
In November, the ECB will take on new tasks of banking supervision as required by the unique mechanism of supervision. In view of the time that the ECB will assume the role of one supervisor of the banking system of the Union, the European Central Bank began in November of 2013 a series of checks on the financial soundness of national banks. This assessment goes through two major stages: asset quality review and an endurance test, or stress test.
Sunday, October 26, the ECB will announce the results of the comprehensive assessment; so banks and investors will know the truth about the health of European banks under scrutiny by the ECB. Yesterday, the Spanish news agency Efe announced that it will be 11 European banks that fail the verification European Union, 3 of which are Italian. The ECB has immediately denied the rumors, but the tension on the markets had already begun to be felt.
124 European banks are subject to checks on their strength, about 85 percent of the entire banking system of the Union.
To sum it up, the stress test is intended to determine whether the banks have sufficient capital to withstand more difficult economic conditions than is currently expected. In practice, this is a simulation through which the assessment of the risks which banks would face in case of any worsening in the level of GDP, unemployment, growth of the inflation, stock market information.
Last January The EBA announced the parameters for banks to pass the tests in Europe: in normal situations banks will be required to achieve core tier 1 (ie, the most “valuable” of the capital of a bank) equal to 8 percent of risk-weighted assets for the base layer and at least 5.5 percent in the scenario of economic difficulty with the simulated stress test.
Alongside with the stress tests, the banks are also facing the asset quality review, or careful analysis of bank balance sheets, the quality of their assets, the criteria and the severity with which non-performing loans are registered that are likely to be lost.
The ECB has analyzed the budget and the banks’ capital on December 31, 2013. In the first instance the increases of the capital gained by the institutions during 2014 (as MPS has recapitalized 5 billion) are not taken into account.
Let’s see the possible scenarios which the banks are going to meet:
- In the event that a bank fails to achieve a core tier 1 capital required by the EBA in the simulated situation of economic shock, the ECB occurs if in the course of 2014 there has been a satisfying strengthening of capital. In this case we can say that the bank has passed the stress test by a hair’s breadth.
- In the second scenario, the bank has not passed European verification and also considering the possible reinforcement of 2014, the ECB does not consider its assets sufficiently solid. In this case the rejected bank has 15 days to enact a recovery plan in case if slight slippage of the parameters required by the EBA could be only an allocation of capital. After the launch of the repayment plan based on the level of slippage of the core tier 1, the bank has 6-9 months to come into compliance.
- In this scenario, the level of slippage of the common equity tier 1 is consistent and the provision prescribed in the preceding example is not enough to restore the bank in the parameters. In this case, the bank may be forced to dispose of assets in order to find the necessary funds to strengthen the capital. This may make the indexes in the stock market fluctuate.
- In this scenario, the bank is forced to a capital increase. This situation can prove to be complex for the institute: the announcement of an increase in capital would have a serious impact on the stock market and presumably also on the rates of the bonds issued by the bank. A “downgrade” or a rating cut on the level of solvency of the bank with more impact on interest rates and cost of collection are also conceivable.
- The last scenario is the most dangerous for the bank and its depositors. In this case the bank is not able to obtain the resources needed to catch up even through the capital increase. The only way out would be a merger with another, more solid, institution, with serious repercussions on the share price on the stock exchange and the rates of bank bonds. In this scenario, a downgrade is almost inevitable.