EU bank stress tests create capital confusion
European Union bank stress tests have created confusion over capital. The best way to restore confidence in the sector would be to see how a crisis affects lenders’ core Tier 1 capital. But that would require EU-wide unanimity over how to define it.
The industry’s official measure of capital — Tier 1 — was discredited during the crisis because it included items like deferred tax assets and hybrid bonds, which cannot absorb losses while the bank is still in business. Regulators are now shifting towards a measure that includes just loss-absorbing equity — often known as core Tier 1 capital.
But the term has been stretched, particularly by governments. Not all injections of state capital to bust lenders were like the 28 billion pounds of pure equity pumped into Lloyds Banking Group and Royal Bank of Scotland in October 2008. Plenty of bailout cash resembled debt, including the German government’s 18 billion euro “silent participation” stake in Commerzbank. Nevertheless, the German lender counts this towards its core Tier 1.
Stress testing for core Tier 1 would therefore risk comparing apples and pears. That’s a shame, because insisting on a tighter definition of capital would raise the bar for the banks that are being put to the test. This, in turn, should improve the market’s confidence in the results.
What’s more, Europe’s biggest banks look like they would pass anyway. Many have either been recapitalized with genuine equity, or are expecting recovering profits this year and next.
Assuming a cumulative two-year probability of default rate of 15 percent on property and corporate loans, a 10 percent loss on mortgages and stringent haircuts on their sovereign debt, almost all big European banks could still retain a 6 percent core Tier 1 ratio, according to Reuters Breakingviews calculations.
However, focusing on core Tier 1 would probably hit smaller state-owned banks. Germany’s landesbanks have an average core Tier 1 ratio of only 5.9 percent but a total Tier 1 average over 9 percent, according to KBW. Using core Tier 1 capital would probably mean taxpayers having to stump up much more.
This gives governments an incentive to fudge the capital numbers. But doing so risks undermining the stress tests themselves. As regulators prepare to publish the results on Friday, the current confusion does not bode well.