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EU Bank Stress Test Raises Hurdle, But Lacks Key Details

The European Banking Authority has raised the capital hurdle for its European-wide bank stress test this year, but the robustness of the exercise will depend on final methodology and scenarios, and how regulators apply certain discretions, Fitch Ratings says.

"We expect additional capital needs to emerge from the stress test, but these are impossible to quantify at this stage. Banks across northern Europe should be able to address capital needs from internal sources, while banks with shortfalls in the more stressed environments of southern Europe may need to turn to external markets and more meaningful deleveraging through asset sales.

The outcome of the test will depend on methodology and scenarios scheduled to be published in April. It will also depend on how the regulators - the ECB for eurozone banks and national supervisors for others - apply certain discretions. For example, the scenarios will include haircuts for sovereign bonds, but regulators can currently filter out unrealised losses for available-for-sale sovereign debt from banks' capital calculations. There is uncertainty about how the filter will be applied in the test and how risk weights for held-to-maturity sovereign bonds may be altered. Transparency will probably be limited until the treatment is disclosed in October, when the stress test results are published.

Regulators may also assess the stress test using other thresholds, including a fully loaded Basel III common equity Tier 1 (CET1) or leverage ratio. We believe the ECB could be stricter than some national supervisors it is taking over from in applying some discretions and determining bank-specific supervisory measures.

There is significant overlap among the 124 banks participating in the 2014 EBA stress test and the 124 covered by the ECB's concurrent comprehensive assessment. But there are important differences. The ECB's review includes eurozone banks that will fall under the single supervisory mechanism as part of banking union. This includes subsidiaries of banks regulated elsewhere, such as Estonian subsidiaries of Swedish banks or subsidiaries of US bank groups.

The EBA stress test covers banks in the whole of the EU at consolidated level, so Swedish banks such as SEB are included but not their Baltic subsidiaries. It includes banks in Denmark, Hungary, Poland, Sweden and the UK as well as eurozone countries. It also includes a bank in Norway, which is not in the EU. Six EU countries are not included on the EBA list because their largest banks are part of a banking group already subject to the stress test.

The ECB's comprehensive assessment includes a supervisory risk assessment, an asset-quality review (AQR) and the stress test. Only the last element is aligned with the EBA test. The risk assessment and AQR are separate exercises to ensure risk weights and loan provisions are adjusted where necessary, before the stress test goes ahead. This is similar to the UK's stringent capital exercise in 2013, when the regulator adjusted asset values, risk weights and conduct redress costs to ensure the reliability of banks' capital positions.

The EBA set a pass mark for the adverse scenario at 5.5% last week, half a percentage point above that for its 2011 test. The CET1 hurdle is also tougher than the 5% used in US tests. Additional Tier 1 or contingent capital instruments that convert or write down are excluded. But these instruments will be disclosed so investors can analyse to what extent they would mitigate shocks.

The exercise will use capital definitions valid during the 2014-2016 test horizon. This could mean the pass mark is closer to the fully loaded basis, which will be applicable for EU banks from 1 January 2019, and is being phased in between now and then."

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