Interpreting the Stress Test results

- What should we make of the stress tests? "In this report we analyse the outcome of the CEBS stress tests on European banks. These stress tests applied two scenarios to forecast 2011 Tier 1 ratios, including an adverse economic outcome and a sovereign risk shock. Our overall conclusion is that the stress tests were a missed opportunity, and will not increase confidence in the sector. We expect the stronger national champion names to continue to fund (and see value in these names), but risks from uncertainty and volatility will likely continue, in our view."
- A flawed stress test? "We were disappointed with the stress test in three areas. First, we do not find a 6% stated tier 1 ratio target particularly challenging. Second, we have found it difficult to reconcile some banks’ assumptions (some banks have forecast that they will make more pre-provision revenue in an adverse scenario than they did in 2009; we believe that too much reliance has been placed on Q1 2010 run-rates). Third, we think that trading book shocks have not been sufficiently conservative, even before considering sovereign risk. In the adverse scenario, Euro 473bn of impairment (banking book) losses were included, and just Euro 26bn from trading losses, which does not match the experience of 2007 to 2009, in our eyes."
- 7 banks failed to meet the 6% threshold, 31 were between 6% and 8% "Seven banks failed, with an aggregate capital shortfall of Euro 3.5bn versus a stated Tier 1 ratio target of 6%. We do, however, see a risk that banks will be pressured to recapitalize to 8% rather than 6%, and that “near misses” may also end up being expected to raise capital. If we apply an 8% stated target tier 1 ratio, then 31 additional banks would fail, and the aggregate shortfall in capital would be Euro 27bn (and this could rise towards Euro 100bn if we were to disallow hybrids). This may be more representative of the long-run outcome, in our opinion."
- A missed opportunity "We were also disappointed by the stress tests because the capital was available for the banks had a more stringent approach been taken. Between Soffin, FROB, funds available for the Greek banks’ recapitalisation, and already-planned capital raises, we believe that a Euro 100bn recapitalisation requirement could have been met. Indeed, given that FROB and Soffin are expiring at the end of this year, we think that the best chance for a relatively straightforward recapitalisation of the sector has passed."
- Valuations: stuck at 1.0x P/TBV "The European Banks remain stuck at 1.0x price to tangible book value. But differentiation within the sector remains low. Even under a tough stress test, we believe that most of our banks under coverage would have passed. We also still see value within the national champion European banks, especially Lloyds Banking Group, Intesa, Société Générale and Credit Suisse, all of which we think are secure on both funding and capital. But a double-dip recession remains a risk for the sector and our top picks. In our view the CEBS stress tests were a missed opportunity to strengthen weaker banks in the sector in advance of any future potential problems."
DeutscheBank European Banks Strategy 20100725