May 6, 2014 12:07 pm

EU banks binge on capital to avoid stress test failure

Rule-breakers know the best way to stay out of trouble is not to get caught. The same applies to stress tests.

With Mario Draghi, president of the European Central Bank, warning some banks may have to “fail” mandatory minimum capital tests later this year, the region’s financial institutions are redoubling their efforts to raise capital and avoid a regulatory reprimand.

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“Every bank wants to get ahead of this because no one wants to have the stigma of failing,” says Huw van Steenis, banks analyst at Morgan Stanley.

From next year European banks face being forced to take corrective action if they fail to meet the baseline scenario set out in a stress test and need to seek public money.

In response they have raised €35.5bn in capital since last July when they began to factor in the European Central Bank’s asset quality review and stress tests, according to research by Morgan Stanley.

Nearly €26bn of that comes from equity issuance, while an additional €6bn comes from divestments specifically for capital-raising purposes. Banks reaped an extra €3.7bn from unwinding their “carry trade” – taking cheap loans from the ECB, investing in higher-yielding government bonds and using the gains to take more provisions on bad debts.

More is set to come – Morgan Stanley projects up to €60bn in total according to a poll – following the release of the “adverse” scenario for the stress tests released by the European Banking Authority last week. In this scenario EU lenders would have to withstand a global debt markets sell-off, a rise in funding costs, a new recession and steep falls in property and equity prices.

European banks will be required to hold at least 8 per cent of regulatory capital in the stress tests – mostly consisting of shares and retained earnings – to their risk-weighted assets under transitional Basel III rules.

“Now the risk of not doing a [capital raising] transaction outweighs the risk of doing one,” says one senior London-based banking sector analyst.

Excluding gains from carry trades, peripheral banks in Italy, Greece, Spain and Portugal have accounted for €26.7bn of the capital raised. Greek banks – such as Piraeus and Alpha – have also been busy capital raisers, a situation barely conceivable a year ago when many considered Greece virtually off the investment map.

Improved perceptions of safety help: the cost of insuring €10m of banks’ subordinated debt, the first securities in the line of fire after equity if a bank defaults, has fallen to €120,000 from a year high of €158,000 in February according to the iTraxx financials index.

The troubles of some banks in the eurozone periphery, such as Italy’s Banca Monte dei Paschi di Siena, have been well documented. But some analysts think bigger banks could be in for a shock if regulators increase their risk-weights to assets – which determines the amount of capital that must be held.

“The real surprises will be some of the big banks who are considered safe but are not,” says Alberto Gallo, head of European macro credit research at RBS.

“There is almost an inverse relationship between the size of banks and how much regulatory risk they declare – some large investment banks have “optimised” their models over time to show their assets are less risky.”

Deutsche Bank is one such behemoth under scrutiny over its capital strength. Germany’s biggest lender says it is prepared to raise equity in the next two months if regulatory pressure worsens.

In addition, many German banks are exposed to lending that is both capital intensive and illiquid, such as shipping and commercial real estate, which could take a hit after the stress tests.

“The majority of German banks subject to the AQR and stress test are engaged in capital-intensive asset-based finance activities, [which] will probably lead to some visible impact on those banks’ stressed capital ratios under the ECB’s tests,” says Carola Schuler, a banking analyst at Moody’s.

At least markets are supportive. With economic recovery in prospect and a conviction that the worst of the eurozone crisis is over there is a strong appetite among investors to plough money into eurozone banks.

“Any capital building is likely to come through retained earnings in my view but if a big bank were to come out and say we need another €2bn-€3bn they would probably get it done,” says Steve Hussey, head of financial institutions at AllianceBernstein.

“There will be a handful of banks pretty close to the minimum requirements but from where we’ve come from [during the eurozone crisis] banks are in a much better place in terms of capital.”

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