Before we discuss what stress tests for European banks are and why they were conducted — as well as why they matter for the Middle East and North Africa (MENA) region — it is important to understand why these banks are in the position they are in today.
Without dragging everybody through the causes of the financial crisis of 2008, which partially triggered the European sovereign debt crisis of 2010, it is important to know that once the global recession spread throughout Europe it caused consumers, companies and governments to see shrinking incomes in the form of lower wages, profits and tax receipts. These developments in turn led to the realization for many European countries that excessive borrowing — which they had been engaged in for years — is not sustainable.
So when we woke up in early 2010 thinking that the worst was behind us for the global financial markets, we actually saw that a number of countries in Europe — namely Greece, Portugal, Ireland, Italy and Spain — had exceedingly high debt levels. The sum of each country’s government, corporate and consumer borrowings exceeded each of their respective GDPs by more than two times!
In order to restore confidence in the banking system and to measure the banks on a level playing field, the Committee of European Banking Supervisors (CEBS) and the European Commission (EC) stress tested 91 banks covering 65 percent of the EU banking sector’s assets.
The tests looked at a base case scenario versus an adverse case scenario. The adverse scenario tested how the banks would fare if the economies of Europe slowed by 3 percent (drop in GDP) over two years. The purpose of this exercise was to see what the negative impacts would be on each bank’s loan portfolio.
Additionally, the tests examined the impact of deteriorating sovereign debt. Given that a large number of EU banks also hold sovereign debt as an investment vehicle, these tests sought to calculate the impact a deterioration of sovereign debt would have on the banks’ financial positions.
It is important to note here that banks typically see investments in sovereign debt as conservative investments, since Moody’s and S&P both provide ratings on country debt. In the case of Europe, most ratings at the end of 2009 were quite satisfactory. Does this sound familiar?
According to the CEBS, seven banks failed the stress tests. The required capital to shore up these banks was found to be €3.5 billion. Some have said that they do not believe these stress tests were tough enough, and that the amount that the banks require is a much larger number. For example, although the stress tests assumed increased yields, as well as a haircut on sovereign debt, they did not assume that any sovereign would default on their debt.
The worst case assumption was Greece, where a 23 percent write-down on government debt was assumed. Also, an assumption of a 3 percent drop in GDP may be worse than we expect today, but a stress test should test a more extreme downward scenario. Ireland, for example, saw a 7 percent drop in GDP from 2008 to 2009. Italy saw a 5 percent drop over the same period.
In any event, these tests have significantly increased the focus on potential risks, and certainly regulators and bankers are now more aware of the sensitivities in the balance sheets. In comparison to the US stress tests of 2009, the European stress tests were a bit more complicated to undertake. Not only did the European tests entail a larger number of banks, 91 versus 19, they also involved 27 jurisdictions rather than just one.
In understanding the relevance of the European and American stress tests for MENA, it is important to bear in mind that most banks in MENA do not operate in an economy such as those of the US and Europe. Additionally, most banks in MENA have weathered the global financial crisis quite well. But what all banks in MENA should learn from the US and European experiences is how not to repeat the same mistakes made elsewhere.
Managing credit and market risk of a bank’s balance sheet involves a reality based approach. As the economies across the Middle East continue to grow, it is important for banks to stay aware of what is happening around them. Most banks in MENA have low loan-to-deposit ratios (with some exceptions of course), and they are very proud of this fact. As we are seeing in Europe, it’s not just consumer and/or corporate loans that can potentially wipe out a bank’s capital.
The big lesson here for MENA is that borrowing is borrowing, whether it is done by individuals, companies or governments — and at the end of the day, all borrowing needs to be paid back.
James Gohary is Principal Operations Officer of International Finance Corporation’s Access to Finance business line for the Middle East and North Africa. He has over 20 years of experience in acquiring, integrating, and growing banks and non-bank financial institutions. This article was written exclusively for Daily News Egypt.
The findings, interpretations and conclusions expressed in this article are the authors own and do not necessarily reflect the views of IFC, a member of the World Bank Group.
