European banks just completed a “stress test” designed to indicate whether a bank could survive a further economic downturn. The primary measurement in this test is whether the bank is adequately capitalized, another way of saying whether its assets can absorb losses that may occur in such a downturn. Therefore, the definition of capital assets, in this case “Tier 1 Capital,” is critical.
The Test
Assume a cumulative two-year probability of a
- Default rate of 15 percent on property and corporate loans,
- 10 percent loss on mortgages and
- Stringent “haircuts” (write-downs) on their sovereign debt
would the bank retain a 6 percent core Tier 1 ratio?
Tier 1 Ratio Defined
Included in the European bank stress test’s definition of Tier One capital is
- Deferred tax assets. These are primarily losses taken by a bank that are in excess of the amount that can be deducted in a particular year, and are carried forward to future years, which cannot absorb new losses
- Hybrid bonds. These are loans to the bank that are convertible to common stock, which, again, cannot absorb losses.
- “Silent participation” stakes, which resemble sovereign debt rather than cash, which has been injected into banks. Nevertheless, it counts this towards its core Tier 1 capital.
Which Banks Would Have Failed Without Using These Items in Tier 1?
According to Reuters, almost all big European banks would have passed. It’s a different story for the smaller state-owned banks. Germany’s landesbanks, for example, have an average core Tier 1 ratio of only 5.9 % but a total Tier 1 average over 9 %, according to KBW. Using a stricter definition of Tier 1 capital would probably mean taxpayers having to stump up much more in the event of an economic decline as described above.
What Was the Purpose Performing the Test Using Such Lax Standards?
Had core Tier 1 capital been applied without including deferred tax assets, hybrid bonds and sovereign debt, the number of banks that would not have passed the test would have been significant enough to cause panic in Europe and probable further economic downturn.
But, by concluding that only 7 of 91 banks failed the stress test, most people will be reassured that a further economic downturn won’t result in widespread bank insolvency.
Don’t bank on it.
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Thanks for this information – all my family lives Europe and I’m planning to retire there in 3 years. Is the purpose of lax bank testing a prevention of panic and hysterical withdrawal of cash from Euro banks? Is it trying to give the masses a temporary and false sense of security? How does European testing compare to North American?
Hi Ata, and thanks for your questions. They’re good ones. The laxity of bank testing certainly improved the probability for more banks to pass, so I think it’s certainly possible that a primary motivation was to avert panic. As to a false sense of security, I can only say that it appears that the big European banks are safe, and that, as we all knew, there are problems in Greece and Spain (likely Portugal and Ireland, too).
North American stress tests did not include tax loss carryforwards or convertible (hybrid) securities in their definition of Tier 1 Capital. Because US sovereign debt is currently highest investment grade, injection of capital by the US is not analogous to, say, Greece, which is in much worse shape.
Overall, I think the banking system in Europe is not in as good of shape as these tests would show, but the problems are primarily Greece, Spain, Ireland, Italy and Portugal, with larger banks definitely in better shape than the smaller ones.
Thanks for your knowledge, Kitty! I believe all the troubled countries you’ve mentioned are members of the EU. I wonder if what happens to one EU member may have a negative impact on all the other countries in the EU. When I listen to overseas news they all share similar problems, such as high unemployment, low consumer confidence, escalating cost of living etc. Actually, issues not so much different from North America.
That’s an interesting observation, Ata. The difference between Greece and Germany are tremendous, as is the difference between Michigan and Mississippi. Many wonder whether the EU will survive.
Do you have any thoughts on that?
I think lot of people see the similarities between the EO and the former Soviet Union. Too much secrecy, political bullying, bureaucracy, just to name a few. In addition, the 27 countries in the EU are slowly but surely losing their individual identity, freedom and ethnicity. If the EU collapses, Europe will be left with a huge problem! There’d be no one to “bail” them out, except perhaps Russia. History has a way of repeating itself and Russia may offer to “step in, help out” and then take over.
Personally, I’m broken hearted because I think my dream of returning “home” will never materialize as my homeland will cease to exist. Instead, whole Europe will be a totalitarian nation.
I’d be interested in your opinion.
I think EU collapse fears are overstated, Ata. The EU reminds me of the United States, in that it is comprised of seemingly disparate states with a common goal. I believe that Greece will have to renegotiate its debt, but the remainder of the EU appear relatively strong, and will hopefully retain their national heritage.
Whenever I travel to Europe, I’m taken with the sense of history there. In comparison, the US is a teen-ager (and many times acts the part). My opinion is that Europe as a united financial entitiy comprised of separate countries with distinct cultures will survive.
Hope you’re right; I’m probably a pessimist, having grown up under the communist regime. I’m pretty sure that the older generation won’t give up without a fight. The younger people may not be as loyal to their heritage and be more willing to trade it for material goods. I already see this trend in my family living in Europe. They are not yet aware that posessions are only a temporary fix. However, their shopping habits are great for the economy! Thanks for your input, Kitty.
Had to giggle @ your teen-age comment – so true!