Stress testing European and UK banks

May 8, 2009 — Mitul Kotecha

The US bank stress tests are finally over and markets are breathing a massive sign of relief. 10 out of the 19 banks tested will have to raise $74.6bn in equity but none of the 19 banks will become insolvent, with additional capital requirements deemed as “manageable”.

It hardly seemed worth getting all stressed up over the stress tests but the results are likely to prompt much debate about the methodology used and will not put to bed the issue of the health of the US financial sector and potential for even more capital raising in the future. This should be the theme of another post but for now I want to discuss what this means for European and UK banks.

The stress tests raise questions about whether the European and UK banking sector should follow the US.  The US administration has used the ratio of tangible common equity to total assets for its stress tests on US banks. This measure has been labeled as old fashioned but one that investors currently prefer. This is also the measure the IMF has used in its recent calculations to work our additional capital requirements for banks globally.

The IMF financial stability report estimated additional credit related writedowns in 2009 and 2010 at $550bn in the US, $750bn in the eurozone, and $200bn in the UK. The IMF estimates that the ratio of tangible common equity to total assets was 3.7% in the US at end 2008 but only 2.5% in the eurozone and 2.1% in the UK. It concludes that the extra capital needed to increase this ratio to 6% would be $500bn in the US, $725bn in the eurozone and $250 billion in the UK.

So will be there similar stress tests in Europe and the UK? The increased transparency that the stress test results have brought about in the US is good news for investors even if no bank was ever going to fail them but they raise a potentially worrying comparison with European and UK  banks which appear to have been far less forthcoming. The figures have been disputed by eurozone and UK officials but assuming the IMF is right the estimates raise some disturbing questions about financial sector health outside the US.

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Show me the money

May 3, 2009 — Mitul Kotecha

The long awaited results of the US administration’s stress tests for US bank will be announced on May 7th. There have been various rumours and speculation about the details in terms of the extent that banks will require further capital injections and indeed which banks will need such injections. Ahead of the announcement I thought it would be an interesting exercise to look at the potential equity needed in the global financial sector.

Some light on this was shed by the IMF’s recent release of the Global Financial Stability Report in which the fund increased its total estimates of global writedowns to over $4 trillion. The most recent estimates of financial sector writdowns suggest that institutions are only about one-third of the way there.

In other words there is still a considerable amount of writedowns on toxic debt left to be undertaken. The IMF estimated further writedowns in the US in 2009 and 2010 at $550 billion, $750 billion in the eurozone and $200 billion in the UK.

Moreover, they estimate that financial institutions will require $500 billion of additional capital in the US, $725 billion in the eurozone and $250 billion in the UK just to raise the ratio of common equity to total assets (a measure of leverage) to 6%. Even these estimates may prove conservative. After all, the IMF has raised its estimates of total writedowns several times already and will likely do so again. These figures do not even include the need for other financing which when added amounts to around 60% of Bank’s total assets.

The bottom line is that even with all the money that is being provided to financial institutions at present it will be highly unlikely that they will be able to raise sufficient capital if the IMF’s estimates are anything to go by. Consequently balance sheets will contract sharply and deleveraging will continue.  Governments will be forced to provide support for a long time to come and the end result will be either outright nationalisation or alternatively bankruptcy for some institutions that are deemed not too big to fail.  Worryingly the risks are skewed on the downside, especially if the economic recovery is a weak one which I believe is highly likely to be the case.

Posted in bank rescue, Economics, equity markets, Europe, Financial crisis, UK, US, US administration. Tags: , , , , , , . Leave a Comment »

More delay from the ECB

April 3, 2009 — Mitul Kotecha

Once again the European Central Bank (ECB) left markets hanging following its decision to cut interest rates by less than the market expected. Unlike the Bank of England which has been quick and aggressive in cutting interest rates and adopting unconventional policy the ECB has lagged behind due in large part to the difficulty in forging a consensus with so many council members involved in the decision making progress.

The ECB put off a decision to introduce new unconventional monetary policy tools until the May meeting due to the opposing views of various council members which in the end resulted in an unstable compromise. Although ECB President Trichet kept the door open to further easing the room is now limited, with another cut to 1% possible at the May meeting.

This will be less important and less influential on the economy compared to potential new measures that could include purchasing more commercial paper and corporate debt, widening the pool of collateral accepted in market operations and increasing the maturity of loans to banks. Buying government debt still seems unlikely given the technical problems in doing so.

The euro rallied against the US dollar following the ECB’s decision due to the fact that European interest rates remain relatively high compared to the US but a stronger euro will not come as good news for Eurozone exporters who are struggling in the face of a collapse in global demand.

The ECB may have put off the decision to another day but it will not be able to escape forever. The May meeting will be crucial to determine just how quickly Europe’s economy will recover. At the moment the lack of strong action suggests a delay in recovery compared to the US.

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Tough week ahead

March 30, 2009 — Mitul Kotecha

It looked as though it all went wrong today as the bad news just kept on coming. Following reports on Friday that JP Morgan and BoA had a more difficult month in March following a stronger start to the year, reports that UBS would be shedding thousands of staff and would announce billions more in writedowns as well as news of the takeover of a Spanish regional bank by the Bank of Spain hit market sentiment hard. Topping all of this were comments by the US administration that some banks would need more capital in addition to that already provided. The administration also said that bankruptcy may be the best option GM and Chrysler.

This sets up a difficult week ahead, with risk aversion set to rise further and the news unlikely to get any better. Economic news is likely to add to the market’s gloom as US releases such as the ISM manufacturing survey for March and the jobs report will likely reveal further deterioration. Expectations for another hefty drop in payrolls in March could see a total of over 5 million jobs lost so far in the current cycle with many more to go.

The news in Europe will not be much better and as today’s Eurozone sentiment indicators have shown the outlook for the economy remains gloomy. The ECB is likely to cut interest rates but will refrain from embarking on the quantitative easing policies followed by other central banks such as the Fed or BoE. As risk aversion rises the USD is set to continue to strengthen against most currencies this week.

Posted in bank rescue, central banks, Currencies, Economics, equity markets, Europe, Financial crisis, UK, US, US administration. Tags: , , . 6 Comments »
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