Bank Stress Test in Europe – Equity Base Is Still too Small

Before taking over responsibility for banking supervision in the eurozone by the end of 2014, the European Central Bank (ECB) investigates the financial solidity of banks in a stress test. It is a much debated topic what measures against potential capital shortfalls the banks subjected to the stress test have already taken before the assessment begins. For a study dedicated to this concern, the Mannheim Centre for European Economic Research (ZEW) has compared bank balance sheets from the fiscal years of 2012 and 2013.

The study revealed the following results:

1. Compared to 2012, the capitalisation of banks has been improved in terms of equity ratio; however, the equity base of some banks is still too small in the status quo scenario (as of late-2013).

2. When it comes to the absolute value of banks' equity capital, the solidity of the banking system shows no improvements. In the past year, especially the large banks reduced their equity capital (by an average of almost four per cent) instead of increasing it. They have improved their capital ratio by reducing total assets to an even greater extent than equity capital, i.e. by almost 10 per cent on average. However, it would be desirable for banks to increase their equity capital instead of reducing it.

3. The most severe threat for the stability of the eurozone banking system would be a financial market downturn. According to the calculations in the ZEW study, even a relatively moderate drop of 10 per cent would suffice to cause a capital shortfall of EUR 154 bn for a risk-weighted capital ratio of eight per cent, which corresponds to the benchmark set by the ECB for Europe's largest banks. When applying a relatively low benchmark of 5.5 per cent, the banks in the eurozone would still be facing a capital shortfall of some EUR 58 bn. Banks in France would account for EUR 33 bn of this capital shortfall, and the share of German banks would amount to as much as EUR 14.4 bn. If a leverage ratio, i.e. the ratio of a bank's equity capital to its total consolidated assets, of three per cent is taken as a benchmark, Germany would account for the biggest shortfall (EUR 66 bn) in this stress test.

4. It is a problematic finding that many scenarios reveal larger capital shortfalls if the test is based on a leverage ratio benchmark, because in many studies the leverage ratio is seen as a more reliable indicator for the fragility of banks than the risk-weighted capital ratio.

For more information please contact

Clemens Fuest, Phone +49(0)621/1235-100, E-mail fuest@zew.de