The results of the mammoth stress-testing exercise carried out on 130 or so of Europe's banks by the European Central Bank (ECB) and the European Banking Authority (EBA) have finally been released and, on the face of it, the sector has plenty to smile about. Indeed, the results were enough for the Dutch finance minister Jeroen Dijsselbloem to joyfully conclude that "the banking crisis is behind us".
The exercise looked at bank asset quality and sought to determine whether lenders were sufficiently well capitalised to cope with various adverse scenarios - such as a painful 5 per cent contraction in EU GDP by 2016, or a huge hike in unemployment. And while more banks failed the test than expected - 25 compared with the 10-14 banks anticipated - an aggregate capital shortfall of only around €25bn (£20bn) was identified. That's modest compared with €1 trillion of bank equity in the European sector. Moreover, the shortfall is based on lenders' end-2013 figures - factor in the near-€54bn of capital raised since and the shortfall shrinks to €9.5bn. The ECB's review of loan book quality - focused on 123 banks in the eurozone - did add a further €136bn of troubled loans to the sector's total. But analysts at Berenberg point out that this represents a fairly trivial 62 basis points of the assets reviewed.
A glance at the detail, however, does reveal some nasty concentrations of problems. It's unsurprising to learn, for example, that most lenders that failed came from those economies which have suffered the most in the financial crisis. Three banks each in Greece and Cyprus and a hefty nine - with a combined €9.4bn shortfall - in Italy. The poor showing in Italy was significantly down to the haircuts applied to the large amounts of sovereign debt held by the Italian banks. Indeed, analysts at Grupo Novo Banco think that "given the large number of failures in Italy there is likely to be a further round of consolidation". That said, Spain - which suffered one of the deepest recessions in Europe - saw all of its banks pass, with no major provision deficits identified by the ECB.
Quite a few banks only passed by the skin of their teeth, too. Two such laggards are in the UK: RBS (RBS) to an extent, but especially Lloyds (LLOY). RBS's capital ratio under the adverse scenario came in at 6.7 per cent, while Lloyds's reached just 6.2 per cent - not far from the 5.5 per cent minimum threshold. Indeed, Lloyds's ratio missed Deutsche Bank's original forecast - of 8.5 per cent - by a mile. Deutsche reckons this reflects tougher than expected assumptions about loan losses in the two lenders' residential mortgage and commercial credit books. In contrast, Barclays' (BARC) equivalent ratio was a fatter 7.1 per cent and HSBC's (HSBA) came in at a comfortable 9.3 per cent. It's an outcome that could raise questions about Lloyds' and RBS's ability to return to the dividend list in the near term. "This is a larger issue for LBG [Lloyds] where the market assumed a small dividend for this year," notes analysts at Deutsche. That issue may not be resolved until the the Bank of England's stress-tests are released on 16 December.
But such glitches do seem modest when set against the backdrop of the bigger message: that the sector overall is no longer looking fragile. That, however, doesn't automatically mean that it's back to business as usual for the banks. To begin with, there's the economy to worry about. Recovery may be entrenched in the UK, but it's a different matter in the eurozone where the IMF expects economic output to contract 0.2 per cent in 2015. Yet banks need economic growth to make serious progress, as that's what drives demand for credit and reduces bad debts. The unpredictable but painful nature of redress costs and fines for past misconduct is another drag that stress-tests can't easily capture. While the impact of tougher regulatory requirements will mean that the heady returns delivered by the banks prior to the financial crisis are unlikely to be seen again. In short, financial robustness does not automatically add up to an attractive proposition for investors.
Finally, it's worth retaining just a little scepticism about the concept of stress-testing. For now, the international regulatory elite appears convinced that stress-testing is the new litmus test for banking sector health. But is that the right way to go? As analysts at Berenberg wisely point out "stress-tests are static by design yet the world they seek to describe is dynamic". The events of 2008 demonstrate the significance of that observation. We now know that banks can be overwhelmed by fast-moving real world events on a huge scale and it's doubtful that anyone - including the mandarins of the ECB and EBA - can design stress-test parameters that can adequately capture the vast array of possible outcomes.
