Europe’s Stress Test Results Show That Most Rated Banks Improved Their Resilience

The European Banking Authority’s (EBA) results of its EU-wide stress test on 51 banks indicate that most of them have sufficient capital to withstand an adverse stress.

While there was no formal pass or fail threshold for the test, the results reflect the progress that many European banks have made in addressing capital weaknesses in recent years. The 51 banks, representing about 70% of EU banking assets, increased their common equity tier one (CET1) by around €180 billion between end-2013 and end-2015. S&P Global Ratings sees the results of the stress tests as being broadly consistent with our own current assessments. We do not expect immediate rating actions as a consequence of the stress test results.
While the results show enhanced capital strength overall, they highlight potential weaknesses in some banks and banking systems. The results showed that 11 banks in the test had fully loaded CET1 ratios of less than 8% in 2018 under the adverse scenario. Among the weakest performers in the test–when measured in terms of their fully loaded CET1 ratios in 2018, or the decrease in their ratio–under the EBA’s adverse scenario–were:

• Both Austrian banks in the stress test–Erste Group Bank, Raiffeisen Zentralbank Oesterreich (RZB) (included in Raiffeisen-Landesbanken-Holding GmbH).
• Both Irish banks in the stress test–Allied Irish Bank and Bank of Ireland. These banks were particularly affected by the static balance sheet assumption of the stress test.
• Three Spanish banks (from six in the stress test)–Banco Popular, CaixaBank, and Sabadell.
• Two Italian banks (from five)–Banca Monte dei Paschi di Siena (MPS, not rated) and UniCredit. The outcome for other Italian banks in the stress test (UBI Banca, Banco Popolare (not rated), and Intesa Sanpaolo) placed them in the middle of the pack overall.
• Two German banks (from nine)–Commerzbank and Deutsche Bank.
• Two U.K. banks (from four)—Barclays and Royal Bank of Scotland (RBS).

The nature of the weaknesses highlighted by the stress test varies between institutions and markets, with asset quality remaining a key factor, but operating profitability and litigation risk driving sometimes materially different outcomes as well.

Austrian Banks
For Austria, the stress test shows RZB having the third-weakest fully-loaded CET1 ratio in the adverse scenario in 2018, at 6.1%. In part, this reflects its relatively low starting point at year-end 2015. RZB strengthened its capitalization this year as part of a large-scale program to reduce structural complexity and improve its capital position, which is not included in the stress test results. Moreover, we base our ratings on RZB on its integration into the wider Raiffeisen Banking Group (RBG) in Austria. In addition to RZB, which was subject to the stress test, RBG comprises local cooperative banks and regional central banks, which are better capitalized and benefit from more stable income streams than RZB. We understand that a key sensitivity of Austrian banks arises from borrowers who take up loans in foreign currency without related foreign currency cash inflows, a feature still prevailing in Austria and in central and eastern Europe although new foreign currency lending was stopped years ago. For RZB, this is also a key impact from its operations in Poland, which is currently up for sale. We still differentiate the group’s subsidiary Raiffeisenbank International AG, which houses the group’s Central and Eastern Europe (CEE) operations, with a one-notch negative adjustment as we believe that a more challenging economic and political environment might make its CEE operations less strategic to the wider group.
In the case of Erste, the key factors affecting the result are the general declines in operating income, and higher credit losses. The latter results in an increase in provisions of €2 billion compared to the baseline assessment, driven by higher corporate and retail stock of provision and a material reduction in interest income. After the bank’s extensive risk clean-up activities over the last two years, the strengthening of its capital in 2016 and our expectation of more stable positive earnings for the next two years, we adjusted our capital assessment, which is now neutral to the ratings.
A further strengthening of its capital and reduction in risks are base assumptions of the ratings and also reflected in our stable outlook. A more challenging economic and political environment might make it more difficult to deliver on the expected improvement in capital.
We include the weighted economic risk of the two Austrian banks’ operations into the anchor of the ratings on the banks, which lowers the starting point by one notch when compared to a purely Austrian bank. In addition, we consider the prevailing low operating profitability in our assessment of Austria’s banking industry risk, which we consider as one of the relatively riskier banking industries in Western Europe.

Irish Banks
Both Irish banks–Allied Irish Bank (AIB) and Bank of Ireland (BOI)–performed poorly in the adverse stress scenario.
AIB’s fully loaded CET1 ratio in 2018 fell to 4.3%, from a starting point of 13.1% at year-end 2015. This makes AIB the second-worst performer in the stress test, after Italian bank MPS (not rated). BOI’s fully loaded CET1 ratio in 2018 fell to 6.2% from a starting point of 11.3%, making it the fourth-worst performer in the stress test.
The overwhelming reason for this poor performance was weak asset quality and losses on defaulted loans. The stress test makes certain simplifying assumptions to promote comparability, such as a static balance sheet position. In addition to a sharp rise in defaulted loans, this assumption is particularly punitive for Irish banks as low-yielding tracker mortgages and expensive liabilities that mature during the exercise are assumed to be replaced with similar assets and liabilities. That said, the results are consistent with our existing view that, while Irish banks have made substantial progress in reducing the stock of non-performing loans (NPLs) and strengthening their credit fundamentals, much remains to be done. Ireland’s banking system is not yet in a steady-state of normality in the context of low interest rates, muted credit growth, and still-high stock of NPLs (at 20% of systemwide loans at year-end 2015).
Although systemwide coverage of NPLs remains satisfactory at around 51% in our base-case view of macroeconomic fundamentals, the persistently high level of defaulted loans does expose the banking system to a sharp downturn, as the stress test shows. These weaknesses are reflected in our ‘bb+’ anchor or starting point for rating Irish banks. This level remains well below the ‘A+’ long-term rating on the Irish sovereign.

Spanish Banks
Among the Spanish banks, Banco Popular is the most exposed due to its weak asset quality. Our combined assessment of capital strength and asset quality (reflected in our “capital and earnings” and “risk position” scores) is a three-notch negative factor in the bank’s issuer credit rating. For CaixaBank, BBVA, and Santander, the stress test outcome is more due to the low starting point of their fully loaded CET 1 ratios. In our view, all three banks will continue to benefit from their stronger asset quality metrics. In addition, we anticipate that BBVA and Santander will continue to build up capital over the next two years, primarily through high earnings retention. Both banks also benefit from a wide geographic diversification.

Italian Banks
For banks in Italy, the results show that although they are all exposed to comparatively higher economic risks, the performance among them varies significantly. For Unicredit, our combined assessment of capital strength (through our capital and earnings score) and asset quality (through our risk position score) is a one-notch negative factor in the issuer credit rating. This primarily reflects Unicredit’s comparatively larger, though declining, stock of NPAs relative to domestic peers in Italy. For the other rated Italian banks in the stress test–UBI and Intesa Sanpaolo–our combined assessment of capital strength and asset quality is neutral to the rating.

German Banks
The results for German banks show that they are primarily affected by comparatively weak operating profitability, legacy legal risks, and nonstrategic portfolios. We reflect business model risks in our business position assessments, which tend to be a relative weakness in our ratings on large German banks such as Commerzbank. Also, we reflect legal risks in our moderate risk position assessment on Deutsche Bank and in our earnings forecast when projecting its risk-adjusted capital (RAC) ratio. Germany is the only country in the stress test sample for which operating profitability before credit risk and market risk losses is a negative factor for the 2018 CET1 ratio (-0.2% of regulatory risk-weighted assets) in the adverse scenario. We understand this figure includes assumptions on legal charges from conduct risk.
We note that the banks in the stress sample are largely wholesale banking institutions, which may have suffered from the funding credit spread assumptions on senior unsecured and covered bonds in the EBA’s stress methodology.
Germany’s dominant retail networks of savings banks and cooperative banks were not included in the stress test. The credit risk impact on German banks is less negative than the EU average, at -2.1% compared with -3.7% for the EU.

U.K. Banks
In common with other banks in a restructuring and deleveraging phase, the stress-test assumption of a static balance sheet as at end-2015 resulted in a relatively steep decline in capital ratios for Barclays and RBS.
Our ratings on Barclays speak to our forward-looking views on the future shape, size, and risk profile of the group, which the stress test does not incorporate. For example, assumptions based on the large non-core loss in 2015 (and associated static cost base) and businesses that have been exited were not considered during the stress test period. A decline in trading revenues combined with credit losses and operational/conduct risk charges were the main drivers of the decrease in capital. Credit losses were mainly in the corporate and SME loan book in the early years of the stress test and subsequently in the unsecured retail portfolios mostly in the U.S. and U.K.
RBS was the 14th-worst performer in the stress test, with a 2018 CET1 ratio of 8.1% under the adverse scenario. RBS is the only U.K. bank in the stress test to see a negative impact on its ratio from operating profitability before credit risk and market risk losses, and we believe that’s due to operational risk (conduct risk) and other exceptional charges linked to its complex restructuring. These are already reflected in our assessment of RBS’ risk position as a relative weakness compared to U.K. peers.

Stress Test Scenarios
The stress tests involved two separate scenarios:

• A “baseline” scenario, which assumes real EU GDP growth of 2.0% in 2016, 2.1% in 2017, and 1.7% in 2018. This is generally above S&P Global Ratings’ growth forecasts for the EU (see table 1).
• An “adverse” scenario, which assumes real EU GDP contracting by 1.2% in 2016, 1.3% in 2017, and growing by 0.7% in 2018. This represents a 7.1% deviation from the baseline scenario.

The severity of the adverse stress scenario is almost comparable to the assumptions we apply in the capital assessments under our risk-adjusted capital framework (RACF). Under our RACF, we consider that a RAC ratio of 8% indicates that a bank should have sufficient capital to withstand a substantial stress scenario in developed markets. We define an ‘A’ stress scenario as a scenario in which GDP could decline by as much as 6% and unemployment could reach up to 15%, and the stock market could drop by up to 60%. In a change from the EBA’s previous stress tests, the 2016 test includes a stress for conduct risk, which resulted in losses of €71 billion overall, although the disclosures do not show this total on an individual bank basis.

Osman Sattar – Credit Analyst – Standard & Poor’s Financial Services