Stress-test results do little to dampen worries about Italy’s lenders

ANY big announcement about banks made after the markets close for the weekend is bound to bring back dark memories of the 2007-08 financial crisis. Although the results of the latest European bank stress tests, released on July 29th, contained much that was reassuring, they did not dispel investors’ doubts about the industry’s earnings prospects. And in the case of Italy, the tests seemed to exacerbate bigger worries. When the markets opened again on August 1st, they were marked by falls in banks’ share prices; the Euro Stoxx banks index dropped by 3% and almost 5% on successive days.

In aggregate the results suggested that European banks were in a healthier position than when the last exercise was conducted, in autumn 2014. This time the banks began with an average “fully-loaded” capital ratio of 12.6% and ended with one of 9.2% in the tests’ most adverse scenario; that compares with a fall from 11.1% to 7.6% last time. No country’s banking sector ended the tests with an average capital ratio below the 5.2% of Ireland; in 2014, the ratio for several countries was negative, implying systemic insolvency. These figures are flattered, however, by the absence of banks from the still-struggling economies of Greece, Portugal or Cyprus.

But the real focus was on the weakness of specific banks, notably in Italy. The worst of the bunch was Monte dei Paschi, Italy’s third-largest lender. Its capital ratio was the only one to turn negative in the test, at -2.4%, meaning that it would be bankrupt if the tests’ worst-case scenario came true. The bank anticipated this awful result by unveiling a plan of its own a few hours earlier to shore up its finances. The scheme involves increasing provisions on impaired loans from 29% to 40%; moving €27.7 billion ($30.9 billion) of the most troubled non-performing loans, discounted to 33% of book value, off its balance-sheet into a special-purpose vehicle; and securitising and selling these loans to investors.

The losses that Monte dei Paschi incurs as a result of this transaction will be offset by raising €5 billion of new equity, though this is conditional on the successful completion of the bad-loan spinoff. Although investors initially welcomed the plan, with the share price rallying early on August 1st, the bank’s shares fell by a precipitous 16% on the following day as concerns grew that the deal may fall through and that regulators may impose losses on creditors if the capital-raising is unsuccessful.

Health assessment

UniCredit was the second-worst test performer among Italian banks, with a capital ratio of 7.1%. Its second-quarter results reinforced worries about its thin capital cushion, which has dipped from 10.5% to 10.3% since March. Analysts at Morgan Stanley, an investment bank, expect that it will need to raise €6 billion in capital. The bank has already announced the sale of its card-processing business; in the wake of a 17.8% share-price plunge in just three days after the tests, more action to spruce up its balance-sheet is surely needed.

The fall in Italian bank shares extended even to those that performed well in the stress tests, such as Banco Popolare. One fear is that the bad-loan plan laid out by Monte dei Paschi sets a new benchmark for the whole sector. Many Italian lenders still have provisions on impaired loans of below 20%, and value their non-performing loans at much more than 33 cents on the euro. If the Monte dei Paschi deal does indeed set the standard for the rest, Italian banks could need up to €18 billion more in capital, according to Autonomous, a research firm.

The stress test also highlighted other poor performers outside Italy. Allied Irish Bank had a capital ratio of just 4.3% in the adverse scenario, a result that may delay the Irish government’s plans to float 25% of the bank in 2017. Further disappointments included Raiffeisen of Austria, the third-worst performer in the test with a 6.1% capital ratio, and two German behemoths, Commerzbank and Deutsche Bank. Yet despite share-price declines—exacerbated in Commerzbank’s case by the release of a set of poor second-quarter results on August 2nd—the test results are unlikely to force an urgent response.

Indeed, most investors are more worried by chronic ailments than the sort of shocks simulated by the stress tests. Hani Redha of PineBridge Investments, an asset-management firm, says markets are more concerned with bank profitability than solvency. The stress tests were based on the effects of a spike in long-term yields, when continued low interest rates seem more likely to weigh on a sector that depends for its earnings on the gap between short- and long-term interest rates. Banks are tied closely to the economic health of the countries they operate in. As long as low growth persists in Europe, no one should expect its banks to perform all that well.