05 Novembre 2014

A credible process

There are at least four reasons why we believe that the Comprehensive Assessment of the European banking sector – which full results were released by the ECB and the EBA on 26 October – was a credible process. First, it was in-depth; launched more than a year ago, covering more than 130 banks accounting for more than 80% of the region’s bank assets and combining a qualitative review and consistency checks across countries and institutions, this exercise is a solid starting point for the ECB, which will assume the sector supervision from 4 November 2014. Second, it provides market participants with a broad and independently-gathered disclosure on the sector and the tested institutions, which significantly enhances the transparency on their assets and capital. Third, it is forward-looking as it does not only factor in the various capital formation measures implemented by banks since the beginning of 2014, but it also tests the banks’ solvency on scenarios looking through 2016, using both phased-in and estimated fully-loaded Basel 3 computations. Last, it should become an ongoing pillar of the future supervision of the sector by the ECB; although no further detail has been communicated thus far, we expect that such Comprehensive Assessment – or at least its stress test component – will be broadened, improved and performed regularly by European regulators going forward.

Overall, the combined impact of the Asset Quality Review (AQR) and the adverse-scenario stress test on the CET1 ratio of the tested banks was an onerous ca. -410bps, in our view. For reference purposes, this compares with an impact of -150bps in the 2011 EBA stress tests and of -290bps in the latest Fed CCAR published in March 2014 – bearing in mind that samples and scenario assumptions are different depending on the various regulators and timing.

Not the end of credit-friendly strategies

A simple conclusion from the Comprehensive Assessment could be that most European banks are now out of the woods of balance sheet and capital strengthening, as most institutions passed the stress tests and the sector as a whole enjoys excess solvency. Such conclusion is deeply misleading for four reasons, in our view. First, because most of the €136bn of additional non-performing assets and of the €34bn of negative capital impact induced by the AQR has not been recognized – yet – by the relevant banks in their financial disclosure. We believe that this will likely change as the market, regulator and auditor tolerance for such discrepancies will diminish. Second, because the Basel 3 phased-in adverse stress tests de facto create two types of banks in need for additional capital; those which failed the test – 13 institutions with a ca. €10bn of capital shortage factoring in the YTD 2014 net capital formation – and those which passed the test but which excess capital seems too thin to get the benefit of the doubt – we estimate that 17 and 30 banks have a theoretical surplus of CET1 of less than 150bps and 250bps, respectively. Banks in those two categories will need to strengthen their capital position as soon as possible, in our opinion. Third, because the Basel 3 fully-loaded CET1 ratios – only tested for information purposes at this stage – show less favorable results; the stressed buffer amounts to ca. 210bps only vs. 280bps in the Basel 3 phased-in ratios, with a total of 36 banks failing instead of 25. With the market increasingly looking at bank solvency in the Basel 3 fully-loaded framework, we believe that all banks will have to focus on improving the quality of their capital going forward. Last, because the trend towards higher minimum capital requirements for the largest banks is not abating. Witness the current discussions on leverage ratios and Total Loss Absorbing Capital (TLAC) requirements potentially ranging between 20% and 25% under the auspices of the G20, which could ultimately force European banks to raise up to €1tn of loss-absorbing capital – core equity, AT1, T2, bail-in-able senior debt – in the next several years.

In sum, far from drawing a line below the capital concerns of the European banking sector, we believe that the results of the Comprehensive Assessment design a new roadmap for a continuing emphasis placed on the sector solvency and balance sheet strength. This supports our conviction that the era of European banks being managed in the interest of their creditors is far from being over.

Opportunities in special situations and newly-issued instruments

The direct consequence of the above provides us with two sets of opportunities. First, in a number of legacy special situations – i.e. banks in run-off or in the process of changing their business models – some instruments offer attractive risk-adjusted returns now that the Comprehensive Assessment process is behind us. We are taking advantage of those circumstances to scale up or re-enter certain of our long positions in that space. Second, the fast-growing segment of Basel 3-compliant hybrid capital instruments is increasingly attractive to trade as (i) coupon-deferral and loss absorption risks seem remote for most of the existing issuers of such securities and (ii) the number of “strategic” – and potentially more investor-friendly – transactions in the primary market will likely rise in the coming quarters. All this, in the context of a significant repricing of the AT1 market as yields on most instruments currently range between 6.5% and 7.5% vs. ca. 5.0%-5.5% at the beginning of the summer.