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European Banks Emerge Healthier in EBA 2018 Stress Test

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After almost seven years since the eurozone debt crisis, European banks have regained footing. This is per the outcome of the stress test conducted by the European Banking Authority (“EBA”) based on 2017-end data.

All 48 banks(that were part of the stress test)were able to meet the minimum common equity (CET1) ratio level of 5.5%, which was the yardstick used in earlier exercises. This year’s test did not provide pass/fail grades.

On an average, these banks’ (accounting for nearly 70% of the EU banking sector by assets) CET1 ratio, under adverse macroeconomic scenario, fell from 14.5% as of Dec 31, 2017 to 10.3% by the end of 2020. This is an improvement from CET1 ratio of 9.4% that was recorded when the last stress test of 51 banks under a different scenario was conducted in 2016.

DanièleNouy, chairman of the ECB’s supervisory board said, “The outcome confirms that participating banks are more resilient to macroeconomic shocks than two years ago. Banks have built up considerably more capital, while also reducing non-performing loans, and improved their internal controls and risk governance.”

Unexpected Weak Results From U.K.-based Banks

As mentioned above, none of the banks’ CET1 ratio was below 5.5%, but two major U.K.-based banks — Barclays (BCS - Free Report) and Lloyds Banking Group plc (LYG - Free Report) — were surprisingly among the worst three performers. Barclays ended up with CET1 ratio of 6.37%, while Lloyds was a tad higher at 6.8%. Notably, Italian bank, Banco BPM S.p.A. with CET1 ratio of 6.67% was the third lender with less than 7% ratio.

This reflected the susceptibility of the U.K. banks to weak growth, credit losses and Brexit-related uncertainty.

What’s more surprising is the fact that German and Italian lenders including Deutsche Bank (DB - Free Report) , Commerzbank AG, UniCredit S.p.A. (UNCFF - Free Report) and Intesa Sanpaolo S.p.A. (ISNPY - Free Report) fared far better than the U.K. counterparts. The economies of Germany and Italy are struggling with slump in the nation’s bonds amid political turmoil.

In the meantime, early next month, the Bank of England will come out with its own stress test results, which may show a different picture for these U.K.-based banks.

Backdrop & Tough Scenarios

The primary aim of the stress test is to gauge how much the banks would lose in case of an economic downturn. The test rounds aid in determining how banks would respond to another economic slowdown and a slump in the markets. Hence, the EBA has come up with hypothetical scenarios that were considered while conducting the stress test.

Adverse hypothetical scenarios include stressed real estate market with commercial and residential real estate prices declining 20% and 19.1%, respectively, over the next three years as well as brutal bear stock market. Further, rise in unemployment rate to 9.7%, 2.7%fall in EU GDP and other known risks to the European economy like Brexit fallout with any financial deal and a huge decline in sky-high home prices in Swedenwere parts of the stressful circumstances.

Also, a new accounting standard known as IFRS9, which compels banks to make upfront provisions for expected losses in the future, was part of the hypothetical criteria used for testing banks’ financials.

Road Ahead

Deemed to be the toughest tests since the European Central Bank started the exercise in 2009, this will further help in strengthening the banking system in the region. The aim is somewhat identical to the annual stress test conducted by the Federal Reserve.

Now, the EBA has started tightening its hold over the eurozone banks, aiming at a faster recovery of the European economy. These banks will have to wait till January 2019 for getting individual reports of their results.

With banks taking measures to strengthen their financials and confront challenges, the stress test will further help regulators to check their progress in the same and avert another crisis. Further, this will boost the lending capacity of banks, thereby bolstering their financial position.

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