Tuesday, October 28th, 2014

ECB + AQR = UNCH *

The most important question was never asked

After much speculation the ECB has finally published the results of the stress-test of the Eurozone banking system. The good news is that most of the banks passed (and enough failed for the test to be credible). The bad news is that most of the banks passed, because this suggests that the whole thing was an exercise in spurious precision.

The process has achieved many desirable outcomes. We have much more and much better data about the banking system. As the years go by this dataset will be refined and improved. Banks and their shareholders will come to have a much better understanding of their competitive position. The trouble is that the next crisis won’t look like the last, and the identity of the examiner means that it can’t ask the one question which really matters. The most stressful situation for Eurozone banks comes if one or more countries leave the euro. The second most dangerous is the one where markets try to price the probability of that happening, and the authorities deny that the risk exists.

In normal circumstances the euro will continue to exist and most banks will continue to have enough capital. In abnormal circumstances it doesn’t and many of them won’t. There is no valuation or provisioning system which can cope with the sudden injection of volatility this would entail. We know because it did not cope in 2008 or 2011. The forces which might cause this are completely outside the control of the banks, and the ECB, and are the stuff of raw politics and mass protest. This is not a statement that euro should break-up, merely that it could, and that banks cannot prepare for this.

The capital adequacy of the Eurozone banking system does not depend on a systematic approach to real-estate provisioning. It depends on whether Marine Le Pen looks likely to become the next President of France, whether Beppe Grillo’s Five Star Party in Italy succeeds in getting a million signatures for its euro-withdrawal petition, and whether the UK holds a referendum on EU withdrawal. None of this will be decided in the next few months. So in the meantime we have a Financials sector which is riding high in our European sector rankings. It is currently #2 in the UK, #4 in the Eurozone and #4 in Pan-Europe.

It is tempting to say that investors correctly anticipated a successful outcome to the ECB stress-tests. However our sector reports suggest that Eurozone financials are only now catching up with a rally that started in the US in early July and in the UK in early August. The US sector peaked at #3 two weeks ago; the UK sector achieved its #2 ranking this week. Until last week the Eurozone banks were #6 and it is hard to believe that their current #4 ranking could have been achieved without a strong performance from US and UK banks in the preceding weeks.

The removal of the uncertainty surrounding the stress-tests is clearly a positive. Barring another existential crisis for the euro, the Eurozone banking system is adequately capitalized. This is reassuring, but on its own it is not enough for a fundamental reappraisal of the risks and rewards attaching to the sector. As so often, markets are trying to answer the question that officialdom dare not acknowledge.

* European Central Bank + Asset Quality Review = Unchanged Situation

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