European Bank Stress Test Preview: What To Expect And How To Trade It

While the main event in today’s European bank stress test was leaked moments ago, when Monte Paschi board member Turicchi said that the bank has finalized a bank consortium for a critical capital hike, suggesting that contrary to last minute jitters the bank has found the needed number of willing banks to provide €5 billion in fresh capital it needs resulting in the bank’s 3rd bailout in the past 2 years – this one courtesy of the private sector – there may still be some surprises.

The following preview explains what are the main things to watch for in today’s release.

The latest round of European banks’ stress test results today may highlight vulnerability of some of the largest banks but could also act as a trigger for much-needed reforms, analysts say.

• The results, due at 9pm London time, may remind investors of Italy’s difficult banking situation, and pose downside risks for the euro, say FX strategists; Monte dei Paschi di Siena (BMPS), the ailing lender that was tested, will publish 2Q numbers after European markets close Barclays says any sign there’s progress toward fixing issues in Italy’s banks could trigger a modest euro relief rally.
• ABN Amro analysts say the test is a “missed opportunity” to do a fuller and deeper health check of the banking system in Europe

WHAT’S HAPPENING?

• Just 51 banks with at least EU30b in assets have been tested; that’s down from 123 banks in the previous exercise in 2014; represents ~70% of total EU bank assets
• No bank from Portugal, Cyprus or Greece is included
  • ABN Amro analyst Nick Kounis says the exclusion of 72 smaller banks will significantly reduce the test’s coverage and impact, especially as the smaller banks are the least sound in some countries; of the banks that failed in 2014, only BMPS is being tested
  • Risk types covered by the tests will include credit risk and securitization, market risk, sovereign risk, funding risk and operational and conduct risks; the latter wasn’t assessed in 2014
• The banks are measured against two scenarios, baseline and adverse, covering the three years through 2018
  • Barclays analyst Mike Harrison says in general the toughest year in the 2016 stress test is slightly more gentle than the 2014 exercise; except for the inflation/deflation stress
• Unlike 2014, the results won’t identify banks that passed or failed and no capital hurdle has been set; CET1 ratios will be published
  • “The aim of the 2016 exercise is rather to assess remaining vulnerabilities and understand the impact of hypothetical adverse market dynamics on banks,” the EBA said
  • Banks will also be tested for conduct risk in this year’s exercise, a component not part of prior tests
  • The stress test outcomes will feed into the Supervisory Review and Evaluation process (SREP) of the banks which is expected this year, including setting the Pillar 2 bank-specific requirements
  • If the tests show that banks might breach their total SREP capital requirements (TSCR) under a stressed scenario, regulators can provide capital guidance and impose tougher capital requirements, Fitch credit company says
  • They can ask banks to revise their capital plans and suspend dividend payments; the EBA also leaves open the possibility of regulators revisiting banks’ SREP assessments and TSCR in the event of an imminent TSCR breach

WHAT TO EXPECT

• The test isn’t expected to lead to an increase of the overall level of capital demand in the system, BofAML analysts, led by Richard Thomas, write in client note
  • Expect market players to extrapolate from the stress test to an assessment of the impact on SREP levels, Thomas and team say
• Monti dei Paschi is in focus as the government could try to use the results to seek to waive bail-in and state aid rules so the state can support the financial sector, Rabobank analysts say in client note
• JPMorgan analyst Marco Protopapa says any systemic solution to Italy’s banking situation would require that senate reform isn’t rejected in the autumn referendum
• How the region responds is an important signal about how sensitive European policymakers are to politics after Brexit, which is important for Italy given the vote later this year on constitutional reform and the growing support for the populist Five Star Movement
• Deutsche Bank’s Marco Stringa says a solution to Italian large stock of NPLs is necessary to avoid a slowing in the pace of the already disappointing Italian economic recovery
• Societe Generale credit analysts led by Paul Fenner-Leitao say there’s scope for other banks to surprise on the downside, while both Deutsche Bank and Commerzbank both fared poorly in mock stress tests performed by SG’s equity analysts
  • The adverse scenario assumptions for Austrian equity prices and CEE recessions are notably bearish, they add
• Barclays analysts say any bank with less than (say) a 200bp buffer in the adverse scenario vs. the 5.5% level could face extra scrutiny – either from regulators or the market
  • This would imply that Deutsche Bank, BNP Paribas and UniCredit are potentially vulnerable as well as BMPS, they say

WHAT THE RESULTS MEAN FOR MARKETS

• If today’s stress tests show a drag from lower net interest income, that could spur speculation the ECB will refrain from further cuts in the deposit rate or prolonging QE, ScotiaBank analysts Alan Clarke and Frederic Pretet write in client note
• Fitch says once stress test results are published, greater visibility on when AT1 payments might be interrupted should bolster investor confidence in the market
  • This should support the development of this market, which would be positive for capital planning for EU banks that still need to build up regulatory capital buffers and need to issue securities that could be used for bail-ins, Fitch said yday

HOW TO TRADE IT FOR BANKS

• Analysts at TD Securities say an updated snapshot of the size of the Italian banking sector’s capital shortfall should provide the incentive to finalize plans to solve the problem; while the knee-jerk reaction may be negative, markets will quickly focus on plans for a bail-out in the following weeks
• Barclays analyst Mike Harrison agrees fixing Monte could trigger a relief rally in the sector; but the absence of a systemic solution to Italian NPLs means that move may be limited sp he favors more defensive banks such as ABN AMRO, Swedbank and Virgin Money
  • Any rally could favor higher beta banks in the core including SocGen, as well as higher quality Italian names like Intesa
  • Given the build-up in press speculation, there could though be a severely negative market reaction if there’s no ‘solution’ for BMPS, he says
  • For Deutsche, the immediate risk around the stress test is that the capital market’s perception of the group is enough to warrant some form of intervention, he adds
• ABN Amro analysts say the results will have a limited impact on European bank fixed income markets due to the exclusion of almost all of the failed banks from 2014, the lack of a pass/fail result and the lack of immediate requirements for banks to conform
• Good news for Italian banks would probably be good news for the European banking sector as a whole; could also slow the underperformance of EMU equities relative to US stocks, Patrick Moonen, strategist at NN investment Partners says
• SG analysts expect a compromise on the Italian banking sector could lead to some confidence in the euro area banking sector, although credit demand may continue to be dampened by high uncertainty and low growth prospect; and banks have a lot of issuance still to do over the near to medium term in order to comply with TLAC and MREL
• And investors may see very low ‘stressed’ core tier 1 ratios as a sign of weakness and (potentially) a need for capital; “at best this could get shrugged off by the market. At worse, it could remind investors all isn’t well in Europe even five or six years after the crisis”

FOR RATES

• While there may be some impact on the bank asset prices, most analysts are sanguine about the impact on the sovereign bond markets, especially given the ongoing ECB QE program with SG analysts saying public backstops are likely and desirable, and won’t have adverse consequences on BTP spreads
• Rabobank analysts expect only short-lived and relatively small market reaction in rates on Monday morning
  • Goldman Sachs analyst Francesco Garzarelli sees limited impact on BTPs even on any state interventions in banks as ECB likely to extend its QE program
• Monte Paschi’s announcement of 2H earnings could totally eclipse the stress test results in terms of market impact at the open on Monday morning, says BofAML’s Richard Thomas

MONTE PASCHI

Here are the results just announced by the one bank everyone’s attention will be focused on when the stress test details are revealed:

• 2Q Net income EU208.8m vs est. EU54m loss (6 ests.) ; 1H Net income: €302m; of that however €134 million is a benefit from tax income.
• 2Q rev. EU1.16b vs est. EU1.09b (8 ests.)
• 2Q NII EU486.9m
• 2Q net commissions EU483.8m
• 2Q loan loss provisions EU372.4m
• Transitional CET1 ratio 12.1% end-June vs 11.7% end-March
• La Stampa adds that Monte Paschi approved the sale of €27.7BN in bad loans at a price that is 33% of “value”

Source: Bloomberg

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