EU Economy not doing much to strengthen banking sector

From the latest round of stress tests, the banking sector still shows that the EU economy is not doing much to strengthen the banking sector, a major pillar that needs to be looked at if the faltering economy is to find the rail again. The 2016 bank stress tests are the first since 2014 and were meant to determine whether the banking sector can undergo another major crisis. The main weakness of banks in the EU have been their equity capital’s low ability to absorb losses and stay profitable. Lack of capital still hinders many banks and this has undermined the stimulus efforts that have so far been carried out by the European Central Bank.

Germany’s Deutsche Bank is one of Europe’s largest banks. It was however pointed out as one of the worst performers. The bank had its capital levels fall to below 3 euros out of every 100 euros it holds in asset. In a typical scenario, that capital to asset ratio is perceived too weak to keep the markets confident during any crisis. Experts now hope that having its biggest bank in a vulnerable position will convince Germany that the recapitalization suggestions in the euro-zone is a remedy whose time has come. The recapitalization rules would remedy situations by having some institutions fail while others remain working under higher capitalization standards, with an assurance that capital will be availed whenever they need it.

Irish banks rated poorly

With the release of the data, the Irish banks had already started making attempts to calm the stock markets after the stress tests placed the country’s banks among the worst position. The AIB and the Bank of Ireland had question marks over whether they can absorb losses in case there is a prolonged downturn. The AIB in particular had a capital ratio that may suffer if borrowers fail to repay loans for example.

The AIB is expected to have a Common Equity Tier 1 (CET1) ratio of 4.3% by the end of 2018. The generally required ratio is 5.5%. It places AIB among the laggards of the 51 banks that underwent the stress tests. A falling capital ratio may not always mean that the bank is in distress. For example, the Lloyds Bank had its CET1 ratio drop from 13% to 10.1% between the 2015 end of year test and the latest EBA test. This drop still leaves the bank way above the 5.5% ratio that is generally viewed as workable. Lloyds Bank issued a statement to reassure the public that the bank still remains significantly above its minimum capital requirements.

Some implications

The stress tests still turn a blind eye on the real problem; there is no clear strategy to curtail the big capital shortfalls that banks find themselves in every now and then. The European banking rules have to a great part been weakened by Germany’s reluctance to share risks in the financial system, making the regulators unable to find ways for the ailing banks to be recapitalized. Earlier proposals had suggested that the banks can work as one unit to recapitalize the other banks majorly using taxpayer funds sourced from the wider euro-area. Germany’s blockades have mainly been based around the notion that using the euro-zone funds to recapitalize flopped banks or have them shut down, will lead to massive closures that end up in a banking panic.

The stress tests also left out the Greek and Portuguese banks that were categorized among the weakest in the euro-zone at around the time they were first carried out. Worse still, the stress tests have a prolonged recession or commodity rout as the worst-case scenario, meaning that the banking sector would still be rated healthy as long as there were no commodity routs.