Banks within the EU may have largely passed the stress tests to show how they would survive adverse economic growth in the years to 2018, but the problem with adverse scenarios, writes Brian Caplen, is that the form they take is notoriously difficult to predict or replicate.

Apart from Italy’s long-troubled Banca Monte dei Paschi di Siena (BMPS), all the other 50 banks in the EU’s latest stress tests fared well. No other institution is projected to see its transitional core equity Tier 1 (CET1) capital fall below 6% even after an adverse impact in 2018 of as high as 847 basis points (bps) in the case of Allied Irish Banks and 746bps in the case of Royal Bank of Scotland (again BMPS was an outlier with a 1423bps fall). 

The overriding conclusion is that Europe’s banks are in a strong position, and overall the European Banking Authority (EBA) notes that the starting transitional CET1 ratio across the sample as of December 2015 is 13.2%, compared with 11.1% for the 2014 stress test and 8.9% in 2011. 

Obviously if there is 13% capital in the system, it can take a lot more stress than 8.9% and it is the finishing point that is critical rather than the scale of the fall. RBS, for example, still comes out with a comfortable 8.08% of CET1 and Allied Irish with 7.39%, even after taking the larger hits. 

But in the end it all comes back to whether you believe the scenarios are realistic. The projected economic downturn over the three years to 2018 is GDP falling 1.2%, then 1.3% and then growing 0.7%. This is bad but not catastrophic and in real life the hit is likely to be harder and faster – say 5% in one year and a recovery of 1% to 2% in subsequent years. 

Then it all depends on which parts of the economy are hit – the property market, the stock market, manufacturing – and what that produces in terms of unemployment, impact on wages and government spending. The EBA exercise does try to capture the impact of a 25% fall in equity markets and a 22% decline in property values. 

In its methodology, the EBA says that the exercise is designed to gauge the impact of a rapid change in the risk outlook and subsequent liquidity conditions, weak profitability, concerns over debt sustainability and stress in the shadow banking sector. 

But problems in the banking sector come in many guises and in Italy the worry is currently over high levels of non-performing loans that have been present for some time. What would be the spark that could turn the Italian banking problem into a crisis?

Neither the EBA or any other commentator can really say for sure. So on the face of it the latest EU stress tests look like good news but they are only as good as the scenarios modelled. Real life has a bad habit of compounding such scenarios – the UK deciding to vote for Brexit being the most recent example.   

Brian Caplen is the editor of The Banker.

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