Europe: Favorable Wind for Sunday's AQR Stress Test

Published on October 21, 2014

The European Central Bank will release the long-awaited results of its Asset Quality Review (AQR) and Stress Test of the 130 largest European banks this Sunday, October 26.

Officials from the Single Supervisory Mechanism, who will formally take over their role as supervisors of these banks in November, have already  been in discussions with their assigned banks in order to allow them as much pre-emptive provisioning or adjustment as possible  before the public release of the final numbers.

The ECB is committed to delivering on Sunday a credible and robust assessment of the health of the European banking sector, after which banks will have between six to nine months to meet any capital shortfalls if and as needed.

*** Given the warnings and very long adjustment and lead time provided in the process, it appears to us that beyond some already widely expected pockets of potential shortfall, the stress tests will not provide a major negative shock or surprise to markets. ***

*** ECB President Mario Draghi pointed out on October 9 that since the summer of 2013 banks involved in the “Comprehensive Assessment” exercise have raised about 60 billion Euros of equity and strengthened their balance sheets by around 200 billion Euros. And private estimates put the portion of that equity increase so far this year at between 25-35 billion Euros, the bulk of which has been put into provisions, potentially ending up close to 50 billion Euros by the end of the year. This capital increase in the aggregate has been uneven across jurisdictions, however, and we would fully expect that some banks, for example in Italy, may be asked to take additional provisions. ***

*** But importantly, in the rare or unlikely case a bank cannot meet the required capital standard ratios in the six to nine month period allotted, from what we understand, the guide lines for a “bail-in” that would be applied in case of any need for public fund injection would continue to follow the existing state aid rules issued by the European Commission rather than the stricter Banking Recovery and Resolution Directive (BRRD) “full bail-in” standards that will come into effect “at the latest” on January 2016. The Commission’s hierarchy, listed below, is among other things more protective of senior bondholder rights in case of a bail-in than the BRRD, and does not set as rigid a requirement on subordinated debt haircuts in case of the need for public fund injections by leaving room for exceptions under certain circumstances. ***

The stress test has been conducted based on banks’ closing balance sheets as of December 31, 2013, but has factored in capital measures taken by banks right up until September 30 of 2014. And banks have been pre-empting the test with more aggressive balance sheet contraction and capital-raises than for past tests – which of course explains some of the credit contraction this year in the Eurozone beyond weakness in aggregate demand – but augurs relatively well for the results on Sunday.

European Commission’s Rules on State Aid

The Commission’s rules on State Aid, and in particular the latest Communication of July 2013, which apply until the “full bail-in” BRRD comes into force in 2016, (a country can put the new regime into place beforehand if it chooses) are not as harsh as the BRRD, and could follow the template of the swift Portuguese Banco Espirito Santo bail-out of this summer. Any recapitalization plans would be pre-submitted to the European Commission for approval.

The Commission’s state aid rules communication specifically includes the following key clauses:

41. Adequate burden-sharing will normally entail, after losses are first absorbed by equity, contributions by hybrid capital holders and subordinated debt holders. Hybrid capital and subordinated debt holders must contribute to reducing the capital shortfall to the maximum extent. Such contributions can take the form of either a conversion into Common Equity Tier 1 (16) or a write-down of the principal of the instruments. In any case, cash outflows from the beneficiary to the holders of such securities must be prevented to the extent legally possible.

42. The Commission will not require contribution from senior debt holders (in particular from insured deposits, uninsured deposits, bonds and all other senior debt) as a mandatory component of burden-sharing under State aid rules whether by conversion into capital or by write-down of the instruments.

43. Where the capital ratio of the bank that has the identified capital shortfall remains above the EU regulatory minimum, the bank should normally be able to restore the capital position on its own, in particular through capital raising measures as set out in point 35. If there are no other possibilities, including any other supervisory action such as early intervention measures or other remedial actions to overcome the shortfall as confirmed by the competent supervisory or resolution authority, then subordinated debt must be converted into equity, in principle before State aid is granted.

44. In cases where the bank no longer meets the minimum regulatory capital requirements, subordinated debt must be converted or written down, in principle before State aid is granted. State aid must not be granted before equity, hybrid capital and subordinated debt have fully contributed to offset any losses.

45. An exception to the requirements in points 43 and 44 can be made where implementing such measures would endanger financial stability or lead to disproportionate results. This exception could cover cases where the aid amount to be received is small in comparison to the bank’s risk weighted assets and the capital shortfall has been reduced significantly in particular through capital raising measures as set out in point 35. Disproportionate results or a risk to financial stability could also be addressed by reconsidering the sequencing of measures to address the capital shortfall.

46. In the context of implementing points 43 and 44, the ‘no creditor worse off principle’ (17) should be adhered to. Thus, subordinated creditors should not receive less in economic terms than what their instrument would have been worth if no State aid were to be granted.

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