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Stress test and naked banking in the face of the political risk of public debt | Opinion of Rubén J. Lapetra

Date: May 22, 2024 Time: 11:51:23

A 6% drop in GDP, high unemployment, high interest rates, credit risk premiums and a collapse in stock and real estate prices. Shake it, put it in the simulator and all that remains is to observe how the results and bank balances have deteriorated. It is the imaginary adverse scenario 2023-2025 of the stress tests to which 70 European banks have been subjected by the surveillance troika that conforms to the banking authority EBA, the European Central Bank (ECB) and the European Systemic Risk Board (ESRB). Logically, the seams resist but generally hold up and that is good news for everyone. The bad thing is that risks arise that can be very relevant from now on.

In summary, European banks would lose around 450 basis points (up to 10.4% in 2025) in their CET 1 ratio, which measures solvency based on a bank’s capital foundations in relation to its assets ( risk-weighted, according to the definition). The accumulated losses could be close to half a billion euros in those three simulated years. The seven Spanish entities analyzed in the main test (Santander, BBVA, Caixabank, Sabadell, Unicaja, Bankinter and Kutxabank) start from a worse capital position than the European average but show greater resilience with a lower deterioration in their ratios.

The stress test aims to provide transparency, confidence and, above all, help identify risks so that the great financial crisis of 2008 does not happen again. Solvency and impact on results are seen, but on this occasion investors and analysts were waiting an off-the-chart dish: the health of the euro banks’ bond portfolio. As is well known, 2022 was a widespread disaster for fixed income due to the abrupt escalation of debt and the consequent fall in price. From large sovereign wealth funds to private conservative funds, all suffered losses. But isn’t fixed income fixed? Yes, as long as the coupons are collected religiously, the expiration date is waited for and the issuer redeems that bond, returning the capital to the investor.

The interest in the matter is that, for whatever reason, the debt investor can decide to sell before that expiration and if the prices have fallen, he incurs losses. This is what happened to Silicon Valley Bank (SVB Financial) in March. His clients’ need for liquidity forced him to sell at a loss a large portfolio of bonds that he had recorded as held-to-maturity assets. However, the Fed’s rate hike in the US from 0% to 5% had sunk the market value of that debt. The operation was a blow to him, a ‘hole’ of more than 2,000 million dollars in losses. He tried to cover them with an urgent capital increase in a sale of shares on the stock market that failed. And there the episode of banking panic broke out, which spread to other entities and had the sector on the ropes for weeks until the Fed and the Treasury managed to put a stop to it.

Banks and public debt, in focus

For the European Central Bank (ECB), it has been reason enough to publish an additional document to the EBA and reveal that European banks lose around 73,000 million euros latently in their bond portfolio, mostly public debt, with data up to February this year before the SVB or Credit Suisse crisis. But it is that in the adverse scenario of the stress tests that figure would double. His message is strong: “The ECB asks banks to pay due attention to interest rate risk strategies.” Here the Spanish entities come out badly in the photo with latent losses of 17,793 million euros in February, which is the difference between the book value and its fair value. Proportionally your debt portfolio is worse. Caixabank, owned by the State, is in the lead with 7,000 million. Since most of that portfolio goes to maturity, there are no real losses but there could be in case of need.

The problem is that the current monetary policy scenario is forcing European governments such as the Spanish one to seek a withdrawal from the ECB itself when it comes to selling its debt, after its extraordinary intervention due to the 2020 pandemic. It is the natural and traditionally most active investor in these auctions, but as the stress tests have revealed, it is not in a prudent position to increase its debt portfolio. The European debt crisis from 2010 to 2012 – which ended with the financial rescue of the financial system in Spain – is the best example of what to avoid. The explosion of the risk premium at that time and the collapse of sovereign bonds left a large number of entities suffocated, such as savings banks, without shareholders, managed by politicians and large holders of public administration debt.

There are three main ways to absorb bank losses in a pinch, and they all require money. Own if it is with the profits generated and reserves, or someone else appeals to the resource of existing shareholders or new investors so that they put the necessary capital in a capital increase or buying the so-called CoCos (contingent convertible bonds) that are created for this type of situation. For all of them, it is a vital condition that the banks are profitable and have sufficient capital buffers to be solvent in the event of bad times.

Listed Spanish banks achieved 12,400 million euros of profits in the first half and some politicians have not thought of anything other than criticizing it. Perhaps they do it out of ignorance or bad faith, but as the EBA stress tests have shown, it is necessary for a bank to earn money so that it can survive a crisis or continue buying public debt. It is biting the hand that finances you and invests in making the ‘politics’ of governments a reality. It is enough to remember the SVB case: if there is no own money in a bank and someone else’s does not arrive, then what nobody wants to happen happens: bankruptcy. With it comes the loss of money for shareholders, bondholders, depositors and savers… or the public bailout at a much higher cost. That’s why it’s really critical and necessary for banks to be profitable. This is reality and how a system that cannot be dismantled today is set up. Will it always be like this?

* This website provides news content gathered from various internet sources. It is crucial to understand that we are not responsible for the accuracy, completeness, or reliability of the information presented Read More

Puck Henry
Puck Henry
Puck Henry is an editor for ePrimefeed covering all types of news.

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