Stress tests reveal Europe’s financial fault lines

The twin tower headquarter offices of Deutsche Bank in Frankfurt. The bank has had a bad week, first it was one of two banks to fail stress tests in the US and then overnight its shares fell to 30-year lows after the IMF said that it appeared to be the most important net contributor to global systemic risk. Photographer: Krisztian Bocsi/Bloomberg

This week saw the results of the latest round of stress tests of the largest US banks. Thirty-one of the 33 banks passed them. The two who failed? It’s no surprise that they were European.

Of the 33, only Deutsche Bank (for the second time) and Santander (for the third) failed the tests. It wasn’t that their US arms didn’t have sufficient capital to pass the tests but rather that they failed because of weaknesses in their risk-management and capital planning systems.

Deutsche has had a bad week. Overnight its shares fell to 30-year lows after the International Monetary Fund, having conducted an assessment of Germany’s financial system, concluded that it appeared to be the most important net contributor to global systemic risk.

The US tests flunked by Deutsche and Santander were introduced after the financial crisis and are exceptionally stringent and powerful. Failure to meet them means the US Federal Reserve can restrict dividends and block proposed capital management initiatives, not that Deutsche or Santander were planning capital returns.

The European Central Bank has similar tests, which have been regarded quite cynically even though, once the European Central Bank took control of them away from the European Banking Authority in 2014, it has forced a number of very large capital raisings. Both sets of tests are designed to ensure the banks’ capital reserves and their internal risk-management systems can withstand another severe crisis.

About one in five European banks failed the ECB’s initial tests in 2014. It is now in the process of another round of tests, with the results due to be released over the next few months. The failure of two of the biggest European banks’ US operations to pass the Fed’s tests, again, isn’t a good sign.

The tests take on particular significance in the wake of the “Brexit” vote and the harsh spotlight it has placed, not just on the economy and financial sector of the UK, but also that of continental Europe.

The problems within the Italian banking system have been elevated from a background concern to an immediate issue. (Italy’s perfect storm could topple the EU, June 29)

Italy’s Prime Minister, Matteo Renzi, is trying to exploit the uncertainties generated by Brexit to convince the EU to allow him to breach its rules and use taxpayer funds to recapitalise his teetering banking sector — and try to save his political skin in the process.

Italy was in talks with the EU last weekend, seeking an exemption from the EU rules that would enable it to pump about $60 billion of taxpayer-funded capital into a system that has an estimated $540bn of non-performing loans.

It isn’t just the solvency of Italy’s banks, however, that is being questioned. Europe’s financial system is attracting far closer scrutiny in the wake of the Brexit vote and the savaging of Europe’s financial institutions’ shares that ensued.

There’s long been discussion about Deutsche Bank and the nature of its global operations, which make it more of an investment bank than a traditional savings and trading bank.

While it might be the highest-profile of the European banks generating concern, however, there is a broader set of macro influences on European banks — and insurers and private sector pension funds — that are steadily undermining the health and stability of Europe’s financial institutions.

The major unintended consequences of the European Central Bank’s embrace of unconventional monetary policy and the negative territory into which official interest rates have moved within the EU as a result is that it is hollowing out its banking and insurance sectors and blowing out an already large gap between the assets and liabilities of its workplace pensions system.

The negative rates on the short-term funds banks deposit with the ECB, designed to force the banks to lend more and generate growth, are squeezing banks’ profitability and their ability to attract capital and deposits.

Apart from punishing savers and sending an unintentional alarm warning to potential borrowers about the ECB’s view of the state of the eurozone economy, those negative rates are steadily hollowing out the profitability and stability of the European banking system while failing to deliver the growth they are supposed to promote.

The European banks, because Europe has less developed securitised debt markets, are far more central to the workings of its financial system and economy than the US banks are to the US system and economy. If they are unstable and shrinking the European economy will be unstable and shrinking.

The ECB’s monetary policies are also doing unpleasant things to insurers and pension funds.

Both insurers and defined benefit pension funds (about 75 per cent of Europe’s funds are defined benefit rather that the defined contribution model that dominates here) invest in generally low-risk assets to fund liabilities that are by their nature long-term.

Unhappily, the returns from all risk assets have fallen dramatically across the globe because of the resort to unconventional monetary policies in the US, Europe and Japan.

With rates on the lowest-risk fixed interest securities negligible and risk premia on riskier assets compressed, the yields on the investment portfolios of the insurers and pension funds are being squashed.

At the same time, with risk-free returns at unprecedented lows, the actuarial calculations of their liabilities are being discounted at far lower rates than they have been historically — their short-term returns are falling even as their long-term liabilities are blowing out.

Given the addiction of central banks in the key economies to unconventional monetary policies and the ultra-low and negative official interest rates they generate, nearly eight years after the financial crisis the key settings for European banks, insurers and pension funds aren’t going to change any time soon.

To put the issue into perspective, the European Insurance and Occupational Pensions Authority conducted its own stress-testing of European pension schemes and released the findings at the start of this year.

It concluded that funds in the UK, Netherlands and Germany could face an aggregate deficiency of assets relative to their liabilities of about $1.2 trillion if there were another significant financial shock. Even without another financial tremor, the funds faced a funding shortfall of about $A640bn.

It isn’t just Europe or private pension schemes or insurers. Earlier this year, Citigroup estimated that the value of unfunded and underfunded liabilities for government pension schemes within 20 OECD countries was $US78 trillion (about $105 trillion).

In terms of the concentrated effects of aggressive monetary policies interacting with an already weak financial system within weak economies, however, Europe is clearly the most vulnerable and, in the aftermath of the Brexit vote, its condition is coming under a microscope.

Its banks (particularly those in southern Europe) aren’t, overall, as well-capitalised or as sophisticated in their risk management and capital planning as their North American or Australian counterparts.

Its insurers and pension funds are being steadily destabilised by the ECB’s monetary policies.

Its governments, even if the EU rules allowed them to deploy taxpayer funds to bail out distressed institutions (which they don’t), have limited fiscal firepower to deploy, with debt-to-GDP ratios generally higher today than they were in 2008.

Then there is the global regulatory response to the crisis, which requires banks and insurers to hold significantly more capital and liquidity of higher quality, which means more and more cash that has to be locked up in government securities with minimal yields.

The EU’s financial institutions are — in environments where there is generally very little, if any, real economic growth to generate earnings and organic capital — being strangled.

The key central banks’ responses to the financial crisis, including the ECB’s, may have deferred something worse than the era of meagre global growth (largely provided by China) experienced since 2008.

The time bought, however, while providing an opportunity for the US to strengthen the core of its financial system hasn’t been as gainfully used in Europe. There, the settings overlaying a system whose foundations are already fragile, are now contributing to new and quite threatening instability.

The Brexit vote isn’t by itself a cause of the new waves of scrutiny and fears the EU’s financial system is being subjected to. It has, however, intensified them and should force the EU and its individual members to finally confront fissures in their system that are being exacerbated by their current monetary, fiscal and regulatory settings.