Impacts of recent European bank stress testing | KPMG | BE

European bank stress testing and the asset quality review: An opportunity for longer-term bank profitability

Impacts of recent European bank stress testing

A look at the potential outcomes of European Central Bank stress tests on Eurozone banks.

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The European Central Bank recently finalized the results of its year-long scrutiny of European banks. The direct immediate impacts of the Comprehensive Assessment and asset quality review are limited, since just 25 of the 130 largest Eurozone banks were found to need additional capital. However, these stress tests are now part of a continuing oversight process in the Eurozone and elsewhere, and banks are now pondering the longer-term implications and opportunities. 

Ultra-low interest rates and comparative stability have allowed collateral values to improve and enabled some rebuilding of banks’ defenses against impairment.

Transition to new European banking supervision:

The financial crisis emphasized the need for better banking supervision and oversight of the largest banks within the Eurozone economies. To address the supervisory deficit, and restore confidence and stability, the European Council determined in 2012 to move to a full European banking union within the Eurozone.

A key component of the European banking union 
is the creation of a single supervisory mechanism, with the European Central Bank (ECB) assuming responsibility for all Eurozone banks. Although national competent authorities (NCAs) will continue to carry out day-to-day supervision of medium-sized and smaller banks, the ECB will directly supervise all European banks with assets of more than €30 billion or which are otherwise seen as systemically important – around 130 institutions, constituting about 85 percent of Eurozone banking assets.

Before taking over these responsibilities in November 2014, the ECB was required to undertake a Comprehensive Assessment, including a balance sheet asset quality review (AQR) as at 31 December 2013, of the resilience and stability of the relevant institutions.

Highlights of the European banks Comprehensive Assessment:

The objectives of the comprehensive assessment were:

  • Transparency – to enhance the quality of information available on the condition of banks;
  • Repair – to identify and implement necessary corrective actions, if and where needed;
  • Confidence-building – to assure all stakeholders that banks are fundamentally sound and trustworthy.

There were three components:

  • Supervisory risk assessment, to review key risks, including liquidity, leverage and funding;
  • AQR, to enhance the transparency of bank exposures by reviewing the quality of banks’ assets;
  • Stress testing to examine the resilience of banks’ balance sheets.

The formal results concluded that:

  • There was a capital shortfall of €25 billion at 25 participant banks.
  • Banks’ asset values needed to be adjusted by €48 billion.
  • An additional €136 billion was found in non-performing exposures.
  • The adverse stress scenario would deplete banks’ capital by €263 billion, reducing median common equity tier 1 (CET1) ratio by 4 percentage points from 12.4 percent to 8.3 percent.
Those banks needing to take further action will have to submit plans to cover the shortfalls within a six-nine month time period. It is also likely that stress testing and the AQR process will form a continuing, regular element in the supervisory framework. The current exercise will form a core model for future exercises, with the process and outcomes likely to be studied by other banking supervisors, within Europe and in other jurisdictions, to inform other, similar developments.

Addressing long-term European bank profitability:

The Comprehensive Assessment should improve market confidence in the stability of sound, well-capitalized banks, laying to rest lingering investor concerns. This will give banks a chance to turn their attention to the issue of long-term profitability. Structural returns in the industry remain low, a situation exacerbated by low interest rates, elevated costs and insufficient capital allocation pooling performing assets, all compounded by additional capital requirements.

Assuming relatively stable conditions continue, European banks should have a window of opportunity, underpinned by improved investor sentiment, to develop long-term strategies for restructuring, cost reduction, improved capital allocation and balance sheet optimization. Now that the AQR is out of the way, banks should be able to address them with renewed vigor. 

Questions to think about:

  1. Do you feel the ECB approach will produce lasting stability for Eurozone banks?
  2. How could ECB-style stress testing and AQR be applied in your jurisdiction and what are the implications for your institution?
  3. How effective are your ongoing relations with local regulators to anticipate and prepare for possible supervisory change?
  4. What potential, outstanding supervisory changes in your jurisdiction impede your ability to focus on longer-term profitability?

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