2/9/16: Remember Banks Stress Tests: Tripple Farce and Still No Joy for Ireland

Couple of older, but still relevant notes have stacked up on my virtual desktop over the last few weeks. Catching up with these, here is a post on the banking sector 'bill of un-health' produced this summer by the EBA.


European banks street tests conducted by EBA last month combined the usual old farce with the novel new farce. Just to make sure the punters were not too scared of the European economy’s champions.

Based on Basel III criteria - CT1 ratio of 7% post shock - all but two banks (Italy’s Banca Monte dei Paschi di SAiena Spa and Austria’s Raiffeisen Zentralbank) have managed to escape the tests with CT1 ratios post-shock within the Basel III parameters. Or in other words, everyone passed, save for two who didn’t. Systemically, therefore, EBA can assure us all that euro area banking is just fine. Nothing to see, nothing to worry about.

However, the farce of the tests goes deep than this predicable and historically conditioned outcome. Because this time around, EBA no longer even bothered with determining who ‘failed’ and who did not. Like in Breznev’s USSR, in the EBUSSR, ‘friendship wins’ and ‘no one loses’.

There was another predictable trend in the EBA results. No matter how ‘flexible’ the models fort testing get, no matter how being the ‘stress assumptions’ get, Irish and Italian banks remain the sickest puppies in the entire ward of already not too healthy ones:

But, hey, despite much of the stock markets hullaballoo over recent months, the bidding of banks’ equity has not really done much in terms of beefing sufficiently their capital buffers. So here are some comparatives on 2014 stress tests against current ones.

Note: 2014 stress tests estimated impact of a shock out to 2016, while this year tests are estimating impact out to 2018.

So behold (via @FT):

Italy:

• 2016 state: Transitional CET1 ratio of 6.14 per cent v 8.42 per cent average - under performing the average by 228 bps
• 2018 state: Fully loaded CET1 ratio of 7.62 per cent v 9.2 per cent average - under performing the average by 158 bps
• Signals improvement, on the surface, but this is a cross comparative over tow somewhat different benchmarks

Ireland:

• 2016 state: Transitional CET1 ratio of 7.05 per cent v 8.42 per cent average, undershooting the average by 137 bps
• 2018 state: Fully loaded CET1 ratio of 5.21 per cent v 9.2 per cent average, underperforming by 399 bps
• Signalling, even if we are to totally disregard differential quality, this does not bode too well for Irish financial ‘giants’

FT did provide a handy chart showing changes in stress test shock-level CET1 ratios for Adverse Stress Scenarios in 2014 tests and 2016 tests (never mind the ‘actual’ levels as of 2015, as these are subject to market valuations etc).

What the above shows?

For a tiny banking system, Ireland’s one is sicker than any other. And this comes on foot of years of repairs, recapitalisations, arrears resolutions etc etc etc. Green Jerseying ain’t working, folks. All Spanish banks are performing better than the two Irish flagships. Majority of Italian banks (save for one) are better than the two Irish ‘giants’. All Portuguese banks are stronger than the Irish systemically-important institutions. And none have spent anything close to Ireland on ‘repairing’ their lenders.

Maybe, if we wait long enough, EBA will include a bunch of Greek and Cypriot banks next… to make ours look better…

28/10/2014: Page 75... ECB Washes Out Its Big Bazooka QE with New NPLs...

In the previous (lengthy) post I covered my view of the ECB stress tests results. But, per chance, you have missed two core points on these, here they are, in a neater summary:

Point 1: Stress tests are weak compared to expectations and independent analysts' estimates of capital shortfall (by a factor of up to or in excess of10:1).

Point 2: Stress tests have raised non-performing loans levels in the euro area banking system by EUR136 billion to EUR879.1 billion or close to 9% of the euro area GDP. The increases were recorded in all categories of loans, which in simple terms means the banks have been under-providing for loans losses across all categories of their core assets.

Now, that puts into perspective the ECB's 'big game all-in' shot for TLTROs and ABS purchases targeting to raise ECB balancesheet exposures by... you've guessed it... EUR1 trillion.

Why, despite improving asset markets, stoic rhetoric of deleveraging and historically low cost of central banks' funds, the NPLs are climbing... and by the end of the ECB's big bazooka firing, that EUR1 trillion is probably will be just about enough to cover the outstanding NPLs. Assuming economy does not tank any more, in which case, it might fall short.


Update: Here's WSJ Blogs analysis of the effects application of the tougher quality tests for Core Tier 1 capital would have had on ECB stress test results: http://blogs.wsj.com/moneybeat/2014/10/27/tough-new-rules-would-have-caused-ten-more-stress-test-fails/

26/10/2014: Mind the ECB 'Stress Tests' Gap

The pain of European economy's Japanification is going to be proportionate to the cheering of the ECB 'stress tests' results.

The real problem faced by European economy is that of the depressed domestic demand (investment and consumption). This problem is fuelled by:
1) declining real incomes of those working,
2) continued sky-high numbers of those who are not working (unemployed, discouraged and never-once-employed workers left out in the cold),
3) growing unease amongst older workers about the state of their pensions,
4) rising burden of the state (including state debts),
5) growing pressure of redistribution of income from households and SMEs to politically favoured white elephant projects (e.g. renewables subsidies, large infrastructure spending, farm supports, regional integration etc),
6) un-abating waste at the EU and national levels anchored to corporatist politics selectively rewarding specific interest groups interests at the expense of entrepreneurs, younger workers, ordinary households and domestic firms, and
7) demographic collapse spreading across the continent as populations age and children remain dependent on ever older parents to support their education and transitioning into joblessness.

This real problem is driving down domestic demand, and with it depressing economy, but also spreading rot across the banks balance sheets.

And yet, despite the obvious and ever-deepening macroeconomic crisis of depressed demand, the ECB stress tests released today provide no insight into what can happen to the banks balance sheets should Japanification set in. Worse, the entire exercise of 'stress tests' is once again not much more than a PR stunt dreamed up by the folks who are 'would be' chief economists for the sell-side equity research.


Here's why.

Back in January 2014, two academics published a preliminary assessment of the Euro area banking union capital shortfalls: http://www.voxeu.org/article/what-asset-quality-review-likely-find-independent-evidence.

This identified stressed shortfalls estimated at between €82 billion and €176 billion (4% benchmark capital ratio) and €509 billion to €767 billion (7% capital ratio) based on book capital.  Take the average to compare to ECB results: ca EUR295-470 billion. "The market capital shortfall estimates indicate a capital shortfall of €230 billion (4% benchmark capital ratio) or €620 billion (7% capital ratio) for the 41 publicly listed banks". Take the average to compare to ECB results: EUR425 billion.

Worse, "estimates of SRISK or the capital shortfall in a systemic financial crisis (40% market decline over a six-month period) is €579 billion; 41% is due to downside correlation with the market, while 59% is due to the leverage of these institutions." So compare to 20% decline under ECB tests (across property assets, 30% decline) and get roughly half of the above figure at EUR290 billion.

Ugly? Try next: "Capital shortfall estimates when writing down their net non-performing loan portfolios range from €232 billion (using the C Tier 1 ratio and an 8% threshold as in the AQR) and €435 billion (using the tangible equity/tangible assets ratio and a 4% threshold)." Again, average these out at EUR330 billion or so.

And get this: "There is a high rank correlation between the shortfalls based on book and market capital ratio measures [but] no significant correlation between shortfalls calculated using regulatory (i.e. risk-weighted asset-based) capital ratios and shortfalls calculated under market or book capital ratios… this highlights how flawed risk-weighted asset-based measures can be."

Take the conclusion in with a deep breath: "Cross-country variation in our capital shortfall estimates indicate that:

• French banks are leading each book and market capital shortfall measure, both in absolute euro amounts and relative to national GDP. The capital shortfall ranges from €31 billion (using the equity/asset ratio and a 4% threshold) to €285 billion (using the tangible equity/tangible asset ratio and a 7% threshold). The SRISK stress scenario suggests a shortfall of €222 billion, which corresponds to almost 13% of the country’s GDP.
• German banks are close seconds, although they benefit from a stronger domestic economy with a higher GDP and a greater capacity for public backstops.
• Spanish and Italian banks appear to have large capital shortfalls when non-performing assets are fully written down. Both countries account for about a third of the total shortfall after write-downs. Market-based measures such as SRISK amount to about 6.5%–7.6% of the GDP of both countries."

So a close common value for estimated shortfalls, comparable to the ECB tests is around EUR290 billion for 41 listed banks (not 150 tested by EBA/ECB).

Oh dear, now think ECB stress tests: The ECB stress tests found virtually none of the above problems to be present or pressing (see full release here: http://www.ecb.europa.eu/pub/pdf/other/aggregatereportonthecomprehensiveassessment201410.en.pdf?d2f05d43d177c25c57e065ebdbf80fe7). Instead, the ECB tests estimated shortfall in the banks to be EUR24.6 billion as of December 2013 and that all but EUR9.5 billion of this has been already rectified by the banks.

This is plain mad not only because it is more than 10 times the number averaged out above, but also because the same ECB review found that some EUR136 billion of loans held by the banks as assets should be classed as non-performing. That is an 18 percent hike in one sweeping year. 85% of banks tested had to revise up their bad loans exposures. And this implies that EUR47.5 billion worth of losses is required to bring these 'assets' in line with their true values.

These losses will have to be covered from either more tightening of existent loans costs or via capital raising or by shrinking returns on equity or all of the above. And these losses are at the lower (as noted by independent analysts) end of the range. And these losses are going to impact future capital access by the banks too, as who on earth would want to stake a house on investing in sick banks hiding the true extent of their losses to the tune of 18 percent?!

All in, Euro area banks now have a hole of EUR879 billion in non-performing loans, facing losses of some EUR300 billion, plus. Based on already stretched (by extend-and-pretend measures adopted to-date) loss rate on non-performing assets. Oh, dear…

Table below summarises sources of NPL increases by category of assets:

As of the end of 2013, per ECB own assessment, some 1/5 of all major banks were in the position of facing high risk of going bust. Forward nine months into this year - what has changed? Nothing, save for the following factors:

1. ECB funding became temporarily cheaper (rates down), but LTROs are being replace by higher priced TLTROs and this means cost of funding going slightly up;
2. Assets valuations have improved on massive monetary stimuli. These being gradually reduced (outside the euro area) is going to depress carry trades that have been helping asset prices boom. Asset values might not fall, but realising these values in the markets forward and counting on their further significant appreciation would be equivalent to taking serious risks.
3. Real economic conditions have deteriorated. Which is far from being trivial, as in the long run, asset values and availability and cost of funding should start reflecting this reality. Once they start, there'll be pain on balance sheets. 

What are the safety cushions post-ECB tests? Ugh, rather thin. Of 130 banks tested by the ECB, 25 failed, 31 had core capital ratio below 10% - the safety threshold accepted in the markets. 28 more banks were within a 10-11 percent range. Thus, 84 out of 130 banks tested were either in an ICU or on ventilators.

Looking back at the main findings from January 2014 paper by Viral Acharya and Sascha Steffen, what is striking is the position of the German and French banks. ECB found virtually no problems in both countries banking systems (see Table below):

Table: Banks that failed ECB tests

Look at geographic distribution of losses under stressed scenario:

Setting aside the proverbial 'periphery' (and Slovenia) there are virtually no problems in the stress case across the national banking system anywhere, save for Belgium, the Netherlands, and Luxembourg. Even Italian system is within 1 percentage point of the median losses. You have to be laughing, right?

And the above only holds for 57% of all assets of the tested banks. That's right, the AQR exercise did not cover all assets held by the 130 banks tested.

Meanwhile, macroeconomic risks factored in are rapidly becoming not stringent enough. The ECB tests were based on EU Commission forecasts from Q1 2014. Since then, the forecasts have seen consistent downward revisions. Instead of focusing on the risk of deflationary recession and stagnation (Japanification), the risks tested were based on bond markets stress, plus recession.

There is virtually no material deterioration in ECB assessment results for German banks compared to previous tests. How? We can only scratch our heads. In the last 2 years, German economy has gone from moderate growth to slow growth and is heading into stagnant growth.

Emerging markets risks exposures were non-existent in the view of the ECB tests, except via higher interest rates impact spillover from the US (assumed by the ECB). Neither were the risks arising from the global slowdown in trade flows. So here's a kicker, if rates are higher and there is a global slowdown, impact on banks balance sheets will be most likely lower than if rates are low (and with them lending margins), but there is a secular long term growth crisis in the euro area itself. Second order effects will be smaller than first order effects.

All in, the 'stringent' tests carried by EBA and ECB took 150 banks and banks subsidiaries and found that 25 of these were short of EUR24.6 billion in capital: 16.7% of banks failed, average capital requirement per failed bank EUR984 million, average capital required per all banks tested: EUR164 million. Contrast this with 2011 when EBA tested 90 banks, failed 20 of these (failure rate of 22.2% much higher than 16.7% in this round of tests), requiring them to raise EUR26.8 billion in capital which amounts to EUR1.34 billion per failed bank (much higher than ECB stress tests this time around) and EUR298 million per bank tested (much higher than ECB tests). Yet, 2011 tests were labeled a farce by the markets.

Today's tests are no better. If not worse.

Worse because they fail to account for the real risks arising in the Euro area today and worse because they create a false sense of security within the system. Or maybe they do not. In which case the entire exercise is a PR stunt, with ECB having a different and more descriptive picture of what is really happening in the banking sector. Maybe so… in which case, does the whole charade qualify as market manipulation by the soon-to-be super regulators? Take your pick, either the regulators-to-be are wearing rose-tinted glasses, or they are fixing the market. Neither is a pretty option...

26/12/2013: Strategy for Growth 2014-2020 - A Fruitcake of Policy?

This is an unedited version of my Sunday Times column from December 22, 2013.


It is a well-known fact that virtually all New Year’s resolutions are based on the commitments adopted and promptly abandoned in the years past. Our Government’s reforms wish lists are no exception. Like an out-of-shape beer guzzler struggling to get out of the pub, our State longs to get fit year after year. Most of the time, nothing comes of it: bombastic reforms announced or committed to quietly slip into oblivion. Smaller parts of resolutions take hold; bigger items get buried in working groups and advisory panels. Thus, over the last decade, we have seen promises of reforms across the domestic sectors, protected professions, pensions and health systems, quangos, social welfare, government funding, tax systems, and so on. Virtually none have been delivered so far.

This week’s Strategy for Growth: 2014-2020 is the latest in the series of Governments’ ‘New Year, New Me’ resolutions. It is a lengthy list of things that have already been promised before. With a sprinkling of fresh thinking added. All of it is based on a strange mixture of pragmatism in fiscal targets, resting on economic forecasts infused with an unfunded but modest optimism. Giddy exuberance in confidence concludes the arrangement: confidence that the reforms which proved un-surmountable under the Troika gaze will be feasible in over the next seven years. The entire exercise promises a lot of reforms, but delivers little when it comes to realistic costings and risk assessments of the promises made.

In brief, the new Strategy is a disappointingly old fruitcake: pretty on the outside, inedible on the inside and full of stale trimmings, held together by the boisterous dose of potent optimism.


On Monday, the National Competitiveness Council unveiled its own version of a roadmap to the proverbial growth curve. The 32-page document on the New Economy contained no less than 65 references to the building and construction sector and 39 instances of references to property sector. No other sector of the economy was accorded such attention.

In the footsteps of NCC, on Tuesday, the Government launched its own multi-annual post-Troika policies roadmap.

The core point of the glossy tome is that Ireland needs a combination of policies to get its economy moving again. No one could have suspected such a radical thought. Majority of the policies listed are of ‘do more of the same’ variety. Some are novel, and a handful would have been even daring, were it not for the nagging suspicion that they represent political non-starters.


The plan has three pillars. Pillar one: fiscal discipline to keep Government debt under control. Pillar two: repairing the credit supply system and the banks. Pillar three: create an economy based on innovation, productivity and exports, and… building and construction. If you find any of this new, you are probably a visitor from Mars.

The document fails to provide any risk analysis in relation to all three pillars. Instead, it fires off pretty specific and hard-set targets and forecasts. Normally, the forecasts reflect the impact of policies being produced. In the Strategy 2014-2020 normality is an inverted concept, so forecasts enable targets that justify proposals.

There are two scenarios considered: the baseline scenario (better described as boisterously optimistic) and the high growth scenario (best described as wildly optimistic). None are backed by an analysis of sources of growth projections. No adverse scenario mentioned.

For the purpose of comparison, based on IMF model, Irish GDP, adjusting for inflation is forecast to expand by less than 12.3 percent between the end of 2013 and the end of 2018. In contrast, Government latest plan projects GDP to grow by over 16.1 percent in the case of high growth scenario. Nominal GDP differences between the high-growth and baseline scenarios amount to just 0.1 percentage points on average per annum. In other words, the distance between boisterous and wild optimism in Government’s outlook for the next seven years of economic growth is negligible.

By 2020 we will regain jobs lost during the crisis. But unemployment will be 8.1 percent under the baseline scenario and 5.9 percent under high-growth projections. Both targets are above the pre-crisis levels of around 4.7 percent. Which means that the Grand Strategy envisions jobs creation to lag behind labour force growth. The only way this can be achieved is by lowering employment to labour force ratio. This, in turn, would require increasing labour force more than increasing employment. In other words, the numbers stack up only if we simultaneously reduce emigration and push people off welfare benefits and into the jobs markets, and do so at the rates in excess of the new jobs creation. How this can be delivered is a mystery, although the Strategy promises more reforms to address these.

We will also transition to a fully balanced budget by 2018, eliminating the need to borrow new funds. Of course, we will still be issuing new debt to roll over old debt that will be maturing. Government debt itself will decline to below 100 percent of GDP by 2019. Per IMF latest estimates released this week, our General Government deficit in 2017-2018 will average around 1.5 percent of GDP and Government debt will end 2018 at around 112.2 percent of GDP. By Governments baseline scenario, we will be running a deficit of 0.25 percent of GDP on average over 2017-2018 and our debt will fall to 104 percent of GDP by the end of 2018. Optimism abounds.

To make these achievements feasible, let alone sustainable, will require drastic reforms far beyond what is detailed in the strategy documents. Instead of detailing these, Strategy for Growth: 2014-2020 leaves the major reforms open to future policy designs by various working groups.

For example, the Government Strategy talks high about the need to ensure sustainability of pensions provision. In an Orwelian language of the Strategy, having expropriated private pension funds before, the Government is now congratulating itself on achieving positive enhancements of the pensions system.

Yet, we all know that the key problems with current pensions system in Ireland are two-fold. One: we have massive under-supply of defined contribution pensions plans in the private sector. Two: we have massive deficits in defined benefit schemes that are predominantly concentrated in the public sectors. The Strategy documents published this week simply ignore the former problem. With respect to the latter one, the Government plan amounts to hoping that the problem will go away over time. Overall, going forward, the magic bullets in the State dealing with the vast pensions crisis are exactly the same as before: higher retirement age, gradual closing of defined benefit schemes and more studies into “setting out … long-term plans in this area”.

Another complex of Augean Stables of economic policies left untouched, potentially due to the influence of Labour is the tax system. Current income and social security taxes de facto penalise anyone considering an entrepreneurial venture. The Strategy puts forward no income tax reforms proposals. The document brags about the ‘progressivity’ of our income tax system and promises to retain this feature of the tax codes. Unions will be happy. Entrepreneurs, self-employed, higher-skilled workers, innovators, professionals, younger and highly educated employees, and exporting sectors workers will remain unhappy.

The Strategy admits that “Traditionally in Ireland starting and growing a business is considered less attractive by many than working in larger employers.” It goes on to stake a bold policy claim “to find innovative ways to encourage an entrepreneurial spirit.”

Stripped of fancy verbiage, the ‘innovative ways’ amount to a call to educate us all, toddlers and pensioners alike, about the goodness of entrepreneurship, and develop unspecified policies to make business failure more acceptable. Given the shambolic nature of the personal insolvency regime reforms designed by the current Government, there is little hope the latter objective can be met.

For intellectual gravitas, key marketing and PR words were deployed in the Strategy, promising more assistance, subsidies and supports to entrepreneurs, and more “clusters”. The same Strategy also promised to cut the number of business innovation assistance schemes and streamline business development programmes.

Taken together, these changes suggest that the Irish entrepreneurship environment will remain firmly gripped by State bureaucracy and will continue churning out state-favoured enterprises with clientilist business models. The fact that the said platform of enterprise supports, having been in existence for some 12 years, has failed to deliver rapid growth of innovation-focused high value-added indigenous entrepreneurship to-date seems not to bother our policymakers.

Other elephants in the room – some spotted by the very same Government years ago, while in opposition – are mentioned and, predictably, left unchallenged. One example: the Strategy promises yet another Action Plan to “identify ways to use Government procurement in a strategic way to stimulate … innovative solutions.” Back in 2011, this Government has already promised to do the same.

Overall, the fruitcakes of economic policy planning by the Government and NCC both lack vision and details. The two documents do contain some good, realistic and tangible ideas, but, sadly, these are buried beneath an avalanche of unspecified promises and uncontested figures. Risks to implementation of these policies may outweigh incentives for reforms. Lack of realism in expectations may overshadow the potential impact of the proposals.

More fruitcake, anyone? There’s loads left…

Box-out: 

In the latest report published this week, the European Banking Authority (EBA) analysed data from 64 banks with respect to their capital positions and the underlying Risk-Weighted Assets (RWA) holdings. Overall, capital position of the EU banking sector “continued to show a positive trend,” according to EBA, with Core Tier 1 capital holdings rising by EUR 80 billion. This, “combined with a reduction of more the EUR 800 billion of RWAs” means that the EU banks are building up risk buffers at the same time as pursuing continued deleveraging. The latter is the price for the former: higher capital ratios are good for banks’ ability to withstand shocks, deleveraging of assets is bad for credit supply to the real economy. On the net, however, as capital ratios rise, the system is being repaired so the price is worth paying. The improvements, however, were absent in one economy. Per EBA, Irish banks (Bank of Ireland, AIB and Permanent TSB) are unique in the EU in so far as they are experiencing simultaneous reduction in capital ratios and a decrease in Risk-Weighted Assets, which only partially offset the drop in capital. Put simply, Irish banks deleveraging is not fast enough to sustain current capital ratios: we are paying the price, but are not getting the benefits.

EBA chart (click to enlarge):