.
Marcuard's Market update by GaveKal Dragonomics
After the largest and most detailed review of bank assets ever conducted, the European Central Bank published its Asset Quality Review of euro-area banks’ balance-sheets. The results of the ECB’s stress tests suggest the eurozone’s banking sector is pretty solid, even though 13 banks will need to strengthen their balance sheets by EUR 10 bln over the next nine months. Following the ECB’s announcement of additional credit easing measures this summer (TLTROs, asset purchases), the publication of the AQR was the last hurdle in the way of a normalisation of credit supply conditions in the eurozone. Even more importantly, the AQR marks the start of Europe’s banking union project, which should lead to the gradual de-nationalisation and harmonisation of banking systems, and so to a more consistent euro-area. General confidence in the health and transparency of the eurozone’s banking sector now has the potential to improve, with favorable implications for financial markets and the economy.
Over the last year, thousands of inspectors have combed through the books of 130 eurozone banks, probing assets worth EUR 3.7trn, or 58% of their risk-weighted portfolios. According to the banks, this has been a surprisingly broad and intrusive process, with a large share of banks’ assets checked in detail, especially those assets most liable to misstatement. The results indicate that at the end of 2013, the value of bank assets was overstated by EUR 48 bln, while under harmonized standards non-performing loans were understated by EUR 136 bln.
The stress tests reveal that under adverse economic and financial conditions, bank capital ratios (the common equity tier 1, restated on the basis of the findings of the AQR) would decline from 12.4% to 8.3%, well above the 5.5% minimum threshold.
However, the ECB found that at the end of 2013, 25 banks were overly vulnerable to adverse scenarios, although 12 have already addressed their capital shortfall by raising equity and selling bad assets. Since the summer of 2013, banks’ balance sheets have been strengthened by EUR 203 bln through the issuance of equity and contingent convertibles, earnings and asset sales. As expected, Italy and Greece face the biggest problems, although even there the capital shortfall does not look insurmountable.
This does not mean that the eurozone’s banking sector, which suffers from obvious overcapacity, has suddenly become rock solid and immune to shocks. But the AQR and stress tests should accelerate the process of defragmentation, ending the credit crunch in Europe. Monetary policy should now stand a greater chance of reaching the real economy, and a modest increase in aggregate credit appears credible next year.
In addition, the AQR was also the first step of a long march towards banking union in continental Europe, with the 130 tested banks coming under the supervision of the ECB from 4 November this year. With the European Commission also proposing a capital markets union, the project should gradually reduce the large differences among national banking and credit markets, helping companies and individuals to diversify their sources of financing. If cross-border mergers and acquisitions take place (as is now more probable), the links between sovereign risks and bank risks would weaken, strengthening the resilience of the euro. Already, we can see that, apart from rare exceptions like Dexia, ‘multi-local’, pan-European and global banks tend to be more resilient and profitable than very local banks.
In this respect, it is no coincidence that following the vicious Darwinian selection that has taken place since 2007, geographically diversified banking institutions make up the lion’s share of market capitalisation in eurozone bank indexes: seven of the eurozone’s 10 most highly capitalised listed banks, representing two-thirds of the MSCI EMU bank index, get more than half of their revenues from outside their home country. For these banks, the AQR went well, and investors may re-rate them.
Overall, the AQR should be bullish for bank stocks as it removes doubts about the real measure of book values. Analysts and investors will now read the AQR to identify the most solid banks, as well as the potential targets. With most bank shares trading below book value, and with dividend yields above 4%, the potential upside is significant.
In a context of resurgent worries about the eurozone, and with economic weakness and political divisions raising doubts about the sustainability of the 2012/2013 relief rally, the publication of the AQR and the associated launch of the ‘banking union’ should help to limit the downside, and could even revive some optimism about the eurozone. Along with the expected benefits from a weaker euro, lower oil prices and reduced fiscal drag, the AQR makes the case for a re-acceleration of the economy next year more compelling.
