On Friday, the Committee of European Banking Supervisors (CEBS) announced the results of its bank stress test and--somewhat unsurprisingly--84 of the 91 banks subjected to the test passed, including all of the European banks that we cover. Moreover, the seven banks that failed were collectively deemed to need only EUR 3.5 billion of new capital. Unfortunately, the stress tests had two major deficiencies, in our opinion. Most glaring is the fact that the tests did not include the possibility of a European sovereign default. While there is room for disagreement over the probability that Greece, Spain, or Portugal will actually default on its obligations, it is clear to us that the possibility they may do so deeply concerns the market. In past sovereign defaults, bondholders have taken massive losses, while the European stress test contemplates much lower loss rates. Furthermore, loss estimates are confined to the banks' trading portfolios, though many sovereign bonds are held to maturity. In the case of even limited sovereign defaults, vast swaths of equity in southern Europe could be wiped out. About 17% of National Bank of Greece's assets are tied up in Greek government bonds, for example.
The other major deficiency that we see is that the bar to pass the test, a 6% Tier 1 ratio under the adverse/sovereign stress scenario, was not high enough. On the surface, the 6% Tier 1 bar seems to be identical to the 6% Tier 1 threshold used in the US tests. However, the US tests also included a 4% Tier 1 common stock ratio requirement, which was arguably the more important test for many banks. The European tests include no similar measure to sort out the highest-quality equity with the largest ability to absorb losses. This might have made a considerable difference for some banks, like KBC, for example, which has nearly half of its current equity supplied by non-voting government capital.
Overall, we think the tests could marginally improve market confidence in the European banks, especially if Europe's recovery continues to be stronger than expected (as with the unexpectedly strong UK growth reported on Friday). However, the results have no impact on our opinion, or our fair value estimates, for the European bank stocks we cover.
