Axel Weber, former president of the Bundesbank, who was once thought to be the most likely successor to Jean-Claude Trichet as head of the European Central Bank, where he was a member of the governing council, is in no doubt that the key uncertainty facing European financial markets next year stems from the central bank he quit unexpectedly in 2011.
Now chairman of UBS, Weber says: "I think we’ll see new problems in Europe as the [ECB’s] asset quality review (AQR) and stress test is playing out, largely because there will be a point in time when markets start to ask what is the likely outcome for each of the 130 financial institutions involved. And unfortunately there are many ways to speculate on those outcomes, such as shortening the stock or selling long positions." It is widely assumed that the ECB, in its de facto first act as lead regulator of Europe’s most important banks before de jure taking on that role next November, cannot afford to blow its credibility. If it does so, that would likely impair its reputation as a monetary authority. And it is hard to see how the stress tests, the final step in the three-part review the ECB will undertake next year, can be credible without some banks failing them.
Second step
Much attention has focused on the second step: the ECB’s asset quality review, looking at banks’ likely NPL levels and current provisioning, their collateral security against potential problem assets and capital resources. But before this, the ECB will also assess banks’ leverage, liquidity and funding before finally finishing with the stress test itself. It will be interesting to see how the ECB assesses the fact that there are large swathes of the European banking system where the ECB itself is the key provider of funding against diverse pools of loan collateral that banks have parcelled up and submitted as security for cash.
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| Axel Weber, UBS |
Weber points out: “At the November meeting, the ECB made a clear commitment to continue with the full-allotment mode of fixed-rate liquidity until 2015, thus signalling to the markets that there will be no short-term liquidity issue for banks while the asset quality review is taking place. But the ECB also indicated that no decision had been taken with regards to new longer-term funding operations, LTROs. That leaves open whether or not all 130 banks post the stress test will all have continued access to unlimited central bank funding. Thus, demonstrating full access and availability of market funding at low market rates will become a key sign of the financial strength of banks next year.” The market is divided. In the weeks after the ECB’s initial disclosure of the surprisingly wide extent and timing of its comprehensive review, some market participants tell Euromoney that the stress test simply cannot be credible if it concludes that Europe’s banks are safe when so many depend on the continuing availability of emergency funding from the ECB. But plenty also say they simply do not buy the argument that the ECB will have to throw one or two banks under the bus to prove how tough it is.
Maybe these optimists did not attend the conference in Berlin last month where ECB executive board member Jörg Asmussen warned: “Credible national backstops must be put in place. If not, the credibility of the whole exercise is put at risk as the outcome will then almost certainly be negatively perceived by market participants. Doing this balance-sheet assessment without a backstop in place would be a bit like getting on a boat in rough weather conditions and not taking a life jacket on board.”
He offers a sop to market purists by saying: “Any recapitalization needs uncovered by the exercise should of course first and foremost be covered by the market,” before emphasizing that “national budgets and national resolution funds may intervene as a second line. Finally, a European backstop, the ESM with its existing instruments, meaning a banking sector programme like in the case of Spain, may be available.”
The ECB seems to be signalling that bail-in of bondholders, even though it might be brought forward to 2015, should not be the first method of repairing balance sheets found wanting by its first regulatory review. But that uncertainty lingers around bank debt.
Too far
John-Paul Crutchley, bank equity analyst at UBS, suggests the rally in bank shares this year might be close to played out, if it has not gone too far already. “Generalist equity investors tell us that they want to buy bank stocks as a geared play on the European recovery. But specialists in the financial sector are worried by the continued drag from impairments in the periphery, by dependence on ECB funding – which if it was refinanced at market rates would certainly hit margins and capital generation – and by the big fines that have hit banks.”
He says: “Regulators certainly don’t want banks to over-distribute to shareholders, and with many recovered banks’ shares trading close to book value and generating a return on equity close to the cost of equity, it’s hard to see much to get excited about from here.”
Meanwhile, Barclays economists, led by Philippe Guding, see broader risks to the European economy if banks hunker down during the review. “We think the timing of the AQR and stress tests remains a material risk for 2014. The risk of seeing the ongoing economic recovery foundering on a credit constraint due to the unwillingness of banks to expand their holdings of risky assets at the time of the banks’ ‘comprehensive assessment’ remains high.”
