Colm McCarthy on Irish banks
The bleak picture of Irish banks painted by the stress tests goes beyond what is reasonable, writes Colm McCarthy
EUROPE’S banking sector continues to generate headaches, and the results of the stress tests, released on Friday evening, have confirmed the overall weakness of bank balance sheets. The results cast a rather negative light on the two Irish banks included in the tests, AIB and Bank of Ireland. This reflects quirks in the methodology used by the European Banking Authority as much as the actual condition of these two banks. Neither is fully repaired but the tests make them look rather worse than is reasonable. The big lesson from the tests is that Europe has yet to deal decisively with the weak balance sheets at so many of its banks.
The banking crises in Europe and America began to emerge in 2007 and intensified through 2008. In the United States decisive action was taken quickly, the economy has recovered and the banks are solvent again. Early in the crisis the US authorities loosened budget policy, cut interest rates and re-capitalised the 20 most important banks. Some key measures were already in place before the close of the Bush presidency at the end of 2008. After a few tough years the worst seems to be over, at least until the next time. But in the eurozone the banking crisis lumbers on as policymakers seek another quick fix for dodgy banks, this time in Italy.
When large parts of the banking system get into trouble, the least painful course is to identify accurately where the problems lie and distribute the losses quickly. Shareholders, bank creditors and taxpayers are in the firing line but early action minimises damage to the broader economy and hastens recovery. With some missteps along the way this is what the US authorities have managed to do. In the eurozone the pattern of early misdiagnosis was followed by blame-games and prevarication. The result is that eurozone banks remain undercapitalised and fragile nine years after the first signs of trouble. There is little or no economic growth, high unemployment and not even a stabilisation of public finances in many countries. Most worryingly, the banks have not been fixed. Nearly all eurozone governments can borrow freely at low interest rates but only because the European Central Bank is willing, for now, to buy their bonds in the secondary market, and in huge quantities. Everyone acknowledges that this so-called QE policy cannot last forever.
The assets of banks, mostly loans to customers, must exceed what they owe, mostly deposits, by a safe margin or the banks are not solvent. The excess of assets over liabilities is equity capital, available to absorb losses on dud loans without placing customer deposits at risk. There are two ways to value the safety margin of equity capital. The first is to look it up in the published accounts. Banks make provisions against loan losses before stating the asset figure. If this is done properly the apparent level of equity capital will be a credible measure of what the bank is worth. But there is a second measure. Most banks have their equity shares listed on stock exchanges. If the books show equity at, say, €5bn for a decent-sized bank, the stock market valuation should also be somewhere around €5bn. It could be more if investors think the bank’s books are sound and it has good growth prospects. But what if the stock market value is way below €5bn? That means investors are not convinced about the adequacy of the provisions for loan losses, and believe the assets are worth less than claimed in the books.
Most European bank shares are currently trading at considerably less than 100pc of book value. Germany’s once-mighty Deutsche Bank trades at just 25pc of book and the weakest of the Italian banks, MPS, at about 15pc. The key factor in these sceptical market assessments is the credibility of provisions against losses on the asset values contained in the published accounts. The market thinks that loan losses will be bigger than has been admitted or that other asset valuations are too optimistic. The consequence is that the banks do not have enough capital, and under-capitalised banks do not lend aggressively into the real economy. Ultimately depositors get nervous and the more troubled banks could face a run.
With the worst of the recession over in most countries, the banks could replenish capital simply by not paying dividends from whatever profits they make over the next several years. Retained profits add to capital. The trouble is that interest rates are low, and likely to remain low, so that healthy profits are unlikely. Moreover, if loan losses have not been adequately provided for, more writeoffs will have to be faced. Without the prospect of painless capital generated from profits, some European banks need injections of fresh capital from outside.
The European Banking Authority published its latest stress test on 51 of Europe’s banks, most of them in the eurozone, on Friday evening. The results confirm the fragility of the eurozone banking system, with one of the Italian banks showing negative capital on some measures. This is MPS, or Monte dei Paschi di Siena, and a hasty re-capitalisation is under way. Somewhat surprisingly the two main Irish banks (the only ones included in the stress tests) came out with low projected estimates of their capital adequacy. This does not mean that either of these banks is below the minimum thought necessary today but that they would be a few years from now if things get difficult. A stress test is a ‘what-if’ projection, not an audit of current condition.
Media coverage of bank stress tests gives the accidental impression that teams of analysts from the supervisory authority have pored over the condition of each bank, taking all of its idiosyncrasies into account and delivering a customised verdict on each one. This is not what the European Banking Authority has done. In pursuit of uniformity of treatment they have instead conducted a mechanical exercise, based on the historic balance sheet from the end of 2015 and assuming difficult trading conditions out to 2019. No allowance is given for extra retained earnings that might emerge to replenish capital, even where these earnings have already arisen in the first half of 2016. The EBA has assumed a poor economic growth performance, penalising banks with extra provisions for loan losses, and downward pressure on the margin they earn between interest charged and the cost of funds. The effect of this procedure is to project a worsening in the condition of AIB and Bank of Ireland beyond what is reasonable. For example, the prospects for the Irish economy embedded in the projections are below the expectations of even the gloomiest forecaster. Against a baseline they assume Irish growth will undershoot by a cumulative 10.4pc over the next three years, while the aggregate Eurozone will undershoot by 6.8pc. Not surprisingly this makes the Irish banks look more vulnerable.
The recovery of Ireland’s two major banks is incomplete, a work in progress. Announcements about the imminent sale of the State’s shares in AIB, or about the resumption of dividends, were premature. But the EBA tests are a little too stressful.
‘A stress test is a “what-if ” projection, not an audit of a bank’s current condition’