The 2014 EU-Wide Bank Stress Test Lacks Credibility

November 5, 2014 9:30 AM

On October 26, 2014, the European Central Bank (ECB) and the European Banking Authority (EBA) released the results of the latest EU-wide stress test and the accompanying asset quality review (AQR).1

The 2014 stress test encompasses four key findings: (1) the aggregate capital shortfall for the 123 banks participating in the test is €24.6 billion; (2) only 24 of the 123 banks are undercapitalized, as indicated by their inability to meet transitional common equity tier 1 capital ratios of 5.5 and 8.0 percent in the baseline and adverse scenarios, respectively;2 (3) the undercapitalized banks are all in Italy, Greece, and Cyprus; and (4) the largest banks in France and Germany have ample capital.3

All of these conclusions are simply not credible. To understand why, consider the following facts and arguments.

1. Over the past five years, a solid body of empirical work has shown that bank capital ratios employing unweighted total assets in the denominator—so-called leverage ratios—are far more effective in distinguishing sick from healthy banks than risk-based measures that use risk-weighted assets in the denominator.4 The 2014 test (like its three predecessors) used only a risk-based measure of bank capital. This is not a technical side-show but rather an issue that cuts to the very heart of the credibility of stress tests.

2. In the run-up to the global financial crisis of 2007–09, risk-based capital measures were indicating that the largest US and EU banks were well-capitalized; by contrast, leverage ratios were indicating that these banks had thin capital cushions (Hoenig 2013, Pagano et al. 2014). Since many of these banks wound up needing official support during the crisis, it is clear which metrics were sending good signals and which were not.

3. During the 2011 EU-wide stress test (the last one conducted before the 2014 test), the bank deemed the safest by its very high risk-based ratio, Irish Life and Permanent, had to be placed in a government restructuring program in 2012. Dexia (a French-Belgian bank) and Bankia (based in Spain) also passed the 2011 test, only to require rescue at taxpayer expense a short time after. A revealing study by two European economists (Verstergaard and Retana 2013) showed that if a 3 percent leverage ratio had been used as the hurdle rate in the 2011 test, 26 banks would have failed instead of 3. Among the failures would have been some large German and French banks, including Deutsche Bank, Commerzbank, BNP Paribas, and Société Générale. A 4.5 leverage ratio would have caught all the banks that subsequently failed. No value of the risk-based measure would have done so, while still allowing some banks to pass the test (Vestergaard and Retana 2013).

4. Beware of claims by executives from the largest French, German, and Dutch banks, emphasizing the credibility of the 2014 stress test results and belittling the results of stress tests done by outside analysts using alternative metrics, including leverage ratios.5 They may well just be talking their book. Because large French, German, and Dutch banks have low leverage ratios and low ratios of risk-weighted assets to total assets, they invariably look better under a test that uses risk-based measures rather than leverage ratios. Indeed, Martin Wolf shows that the gap between leverage ratios and the risk-based capital metric used in the 2014 test is wider for Dutch, French, and German banks at the "center" of the euro area than it is for Greek, Portuguese, Irish, Italian, and Spanish banks on the "periphery."6  

5. Ever since Christine Lagarde (2011), the IMF's managing director, put a spotlight in August 2011 on the need for "urgent capitalization" of Europe's banks, a host of estimates by independent analysts has suggested a significant undercapitalization of Europe's banks. Quite a few of these studies use leverage ratio benchmarks—sometimes supplemented with measures of systemic risk—to gauge the extent of undercapitalization. Acharya and Steffan (2014), for example, continue to find an EU-wide capital shortfall of hundreds of billions of euros—a far cry from the €25 billion EU-wide shortfall arrived at in the 2014 stress test. Moreover, the largest part of that aggregate shortfall resides with large French banks.

6. The Federal Reserve in the United States has been employing a leverage ratio test in its annual stress tests since 2012. The Bank of England has announced that it likewise plans to do so in its own stress tests, due later this year. In discussing the heralded resilience of Canadian banks during the 2007–09 crisis, Mark Carney has testified that "if I had to pick one reason why Canadian banks fared as well as they did, it was because we had a leverage ratio." 7

7. Last but not least, two popular defenses for the existing level of capitalization in EU banks should be discarded. The first argument claims that large EU banks are adequately capitalized if they have approximately the same capital ratios as large US banks. This contention overlooks the "too-big-to-fail" problem, which is more severe in the European Union than in the United States. EU bank concentration—if properly measured at both the individual-country and EU-wide levels—is higher than in the United States. In addition, bank credit accounts for a higher share of total financial intermediation in Europe (see Goldstein and Veron 2011, Pagano et al. 2014). Large EU banks should therefore be holding more capital than their US counterparts, not less, as recent data on leverage ratios indicate.8 The second defense suggests that large EU banks have enough capital if their capital ratios are similar to those of their global peers, broadly defined. But bank capital ratios are almost surely too low everywhere. Drawing on both theory and empirical evidence, Admati and Helwig (2013) make a persuasive case for higher bank capital requirements.9 In a similar vein, 20 distinguished professors of finance (including two Nobel laureates) concluded, in a November 2010 letter to the Financial Times, that bank leverage ratios ought to be about 15 percent and that achieving such a target would generate substantial social benefits, with minimal, if any, social cost.10 This target is far from the 3 percent minimum for the leverage ratio established under Basel III and far from actual leverage ratios maintained by large banks around the world. All of this suggests that the capital hurdle rates used in the 2014 EU-wide stress test are more likely to be too easy (low) than too tough (high).

To sum up, on the eve of becoming the Single Supervisor for Europe's largest banks, the ECB missed an important opportunity to establish trust in EU bank supervision. By refusing to include a rigorous leverage ratio test, by allowing banks to artificially inflate bank capital, by engaging in wholesale monkey business with tax deferred assets, and also by ruling out a deflation scenario, the ECB produced estimates of the aggregate capital shortfall and a country pattern of bank failures that are not believable. This was not a case of "doing whatever it takes" to establish credibility, but rather one of avoiding the tough decisions and asking the market to "take whatever." When it comes to fixing the long-running undercapitalization of Europe's banking system, believe me, what European authorities delivered will not be enough.

References

Acharya, Viral, and Sacha Steffan. 2014. Falling Short of Expectations? Stress Testing

The European Banking System. VoxEU, January 17.

Admati, Anat, and Martin Helwig. 2013. The Bankers New Clothes: What's Wrong with

Banking and What to Do About It. Princeton: Princeton University Press.

Blundel-Wignal, Adrian, and C. Roulet. 2012. Business Models of Banks, Leverage,

And the Distance to Default. Financial Market Trends. 2012.2. Paris: OECD.

EBA (European Banking Authority). 2014. Results of the 2014 EU-Wide Stress Test.

Aggregate Results. London: European Banking Authority.

Goldstein, Morris, and Nicolas Veron. 2011. Too Big To Fail: The Transatlantic

Debate. Working Paper No. 11-2. Washington: Peterson Institute for

International Economics. January.

Haldane, Andrew, and Vasileios Madouros. 2012. The Dog and the Frisbee. Paper

presented at the Federal Reserve Bank of Kansas City's 36th Economic Policy

Symposium, Jackson Hole, Wyoming.

Hoenig, Thomas. 2013. Basel III Capital. A Well-Intended Illusion. Paper presented at the International Association of Deposit Insurers 2013 Research Conference, Basel,

Switzerland.

Pagano, Marco, Viral Acharya, Arnoud Boot, Marcus Brunnermeier, Claudia Buch,

Marin Helwig, Sam Langfield, Andre Sapir, and Leke van den Burg. 2014. Is

Europe Overbanked? Report of the Advisory Scientific Committee, European

Systemic Risk Board. June.

Vestergaard, Jakob, and Maria Retana. 2013. Behind Smoke and Mirrors: On the

Alleged Capitalization of Europe's Banks. Copenhagen: Danish Institute of

International Affairs.

Notes

1. Earlier EU-wide stress tests were conducted in 2009, 2010, and 2011.

2. If capital raising during 2014 is taken into account, the aggregate capital shortfall declines to €9.5 billion and the number of banks with a shortfall to 14.

3. The report on the outcome of the 2014 stress test (EBA 2014) indicates that the AQR resulted in a 40 basis point reduction in the weighted average common equity tier 1 capital ratio. Here I focus on the implications of excluding a leverage ratio from the tests because the quantitative impact of that decision on the size of the aggregate capital shortfall and on the country pattern of shortfalls easily overwhelms the impact of the AQR.

4. See, for example, Haldane and Madouros (2012) and Blundel-Wignal and Roulet (2012).

5. See, for example, letter by Société Générale's Phillippe Heim, "Alternative Stress Tests Cannot Compare with Those of the ECB," Letters in the Financial Times, October 31, 2014.

6. Martin Wolf, "Europe's Banks are Too Feeble to Spur Growth," Financial Times, October 28, 2014.

7. "Mark Carney Sees Logic in Tougher Cap on Banks' Leverage," Independent, September 29, 2014.

8. Pagano et al. (2014) compare mean leverage ratios, corrected for differences in international accounting standards, for globally-systemically-important banks (G-SIBs) in the European Union and the United States. The averages for the second quarter of 2013 were 3.9 percent for EU banks versus 4.5 percent for US banks.

9. Although Admati and Helwig (2013) strongly prefer to measure bank capital by a leverage ratio rather than by a risk-based metric, their overall conclusion about bank capital being way too low also applies to risk-based capital measures.

10. "Healthy Banking System is the Goal, not Profitable Banks," Financial Times, November 9, 2010. See also Admati and Helwig (2013) on why higher minimum requirements for bank capital have a very favorable benefit-cost ratio.