European banks are uneasy. They’re concerned that – for the first time – they face a serious evaluation that could reveal big holes in their balance sheets. While the ECB is due to reveal the results of its ongoing asset quality review (AQR) only in October, officials reportedly will inform banks of serious deficiencies along the way so that the banks can address them immediately (“ECB set to alert banks to asset quality review problems,” FT, April 27, 2014). The fear is that rumors of a significant capital shortfall could trigger funding problems for a bank well before the AQR is complete.
The more nervous bankers are, the safer the system. Anxious bankers are more conservative in valuing their assets. They are more cautious in taking on leverage and maturity mismatches. They pay special attention to counterparty risk. And they are especially diligent in screening and monitoring borrowers.
That’s the kind of healthy anxiety market discipline should impose. But government guarantees blunt socially desirable aversion to risk. Making the banking system safe – offsetting the moral hazard resulting from the government safety net – requires regulation and supervision. This is where we stand today.
Over the past few years, stress tests have become the single most powerful tool of bank supervisors. The Fed’s first stress test, published in May 2009, calmed investor fears in the aftermath of the Lehman bankruptcy eight months earlier. Every year since, the Fed has conducted a Comprehensive Capital Analysis and Review (CCAR) of the largest banks. In addition, the Dodd-Frank financial reform of 2010 now mandates annual stress tests for all systemic intermediaries and all banks with assets of more than $10 billion. [These two exercises overlap substantially, but are distinct.]
Over time, the CCAR has become the binding capital constraint for large U.S. banks. Those that fail the test cannot increase distributions to their shareholders (either through dividends or stock buybacks) – making their investors unhappy. Gradually, banks have been encouraged to raise their capital ratios, rather than distributing all the benefits of low interest rates and rising asset prices to shareholders.
Now, all eyes are on the ECB as it takes on the supervision of the euro area’s largest banks this November. Will the ECB’s new Single Supervisory Mechanism (SSM) prove credible? The first test comes with the combination of the AQR (which measures the value of bank assets) and the stress test that are currently underway. Last month, the European Systemic Risk Board (ESRB) revealed details of the adverse scenario that will be used by the SSM (working with the European Banking Authority) to assess the robustness of large euro area banks’ capital in the stress test.
It will not be easy for the ECB to establish supervisory credibility. Two previous EBA stress tests undertaken in 2010 and 2011 detected few capital shortfalls, only to be followed shortly thereafter by prominent bank failures (Dexia) and a wholesale run on many banks in the euro-area periphery. Unlike the Fed in 2009, which could rely on the Treasury (and its TARP funds) to fill any large capital shortfalls revealed by a stress test, the EBA lacked a large euro-area-wide public backstop, so investors were naturally suspicious of the results.
This puts the ECB in a delicate position. On the one hand, it has an incentive to clean up legacy issues before it becomes the banks’ supervisor. In addition, it may have only one chance to establish its supervisory integrity for the long run. On the other hand, if the review were to reveal a large capital shortfall in peripheral banks, financial stress could reemerge.
Until we receive additional information, we will not be able to assess the rigor of the AQR. What we can say now is that the adverse scenario of the stress test is notably less adverse than the most severe scenario in the Fed’s latest CCAR. As of 2016, both anticipate large real GDP losses, sustained increases in unemployment, and financial shocks, but the U.S. disruptions are larger.
Perhaps most important, the SSM/EBA test examines only a modest widening of euro-area government bond yield spreads over Germany; modest, that is, compared to the devastating experience of just a few years ago. In no case does the adverse scenario go back to the average spread in 2012 (see chart below)!
Long-term Government Bond Yield Spreads over Germany (basis points)
What do investors expect? The equity price-to-book ratios for the very largest European banks suggest that reported balance sheets are more credible than they seemed a year ago (see chart below). Interestingly, the countries with the lowest price-to-book ratios now are Germany and France: perhaps investors are preparing for unpleasant AQR news in those countries, which presumably can recapitalize weak banks without triggering a sovereign crisis. But that still leaves room for unpleasant AQR surprises in the reports on smaller banks and public banks without traded equity.
Price-to-book ratios for Top European Banks, January 2006-May 2014
So, what should we conclude? To judge the credibility of the ECB’s comprehensive review, you can watch closely over the summer (when bad news from the AQR could appear for individual banks) or wait until October and November when the AQR and stress test results will be published. While the ECB is working hard to strengthen euro-area banking supervision, its credibility will depend on keeping euro-area banks anxious for a long time to come (and on pushing euro-area banks’ capital much higher than it is today). Whatever the ECB does over the next six months, it will leave a lasting impression that could determine the long-run health of the European financial system.