European banks in final rush for equity to pass ECB stress tests but uneven capital raising may yet lead to shortfalls

  • 42% of all new capital raisings since last stress tests took place this year
  • 32% more is raised in nine months than in the whole of the year preceding the last stress tests
  • 25% of banks in lower capitalised markets managed to raise capital with half securing 75% of all new raisings

European banks currently completing stress tests under the supervision of the European Central Bank (ECB) as part of its Asset Quality Review (AQR) have raised over €90bn through the capital markets since the last stress tests of early 2011, with 42% of all raisings taking place in the first nine months of this year alone (€34.7bn). Banks from Europe’s lower capitalised jurisdictions accounted for 77% of all 2014 raisings, leading a rush for equity to bolster their balance sheets in order to pass the tests. The capital raisings executed this year so far represent an increase of 32% compared to the whole of 2010, the year before the results of the last stress tests were announced, but concerns remain as to whether enough has been done and whether capital shortfalls will still emerge, according to a new analysis* by Linklaters.

Against a backdrop where banks non-performing loans (NPL) have been on the increase**, Italian institutions accounted for the largest recapitalisation exercise this year, raising over €10.5bn, followed by Greece (€8.3bn); Germany (€6.7bn) and Portugal (€3.4bn).

“Whether any of the 131 banks under review will fail to pass the tests remains to be seen but following three years when new capital issuances have been declining, the capital raisings executed this year clearly show an acceleration by banks to improve their capitalisation in order to get the green light from the ECB”, according to Edward Chan a banking partner at Linklaters.

Between 2010 and 2013, Common Equity Tier 1 (“CET1”) ratios, which measure core equity capital compared with total risk-weighted assets among European banks to highlight an institution’s financial strength, improved on average by 2%, with peaks of 8% for Ireland a lows of  -5% for Cyprus***. By the end of 2013, nine jurisdictions (Italy, Malta, Spain, Portugal, Austria, France, Cyprus, Greece and Slovenia) were home to banks with a collective average tier one capital ratio that was below the European average of 13%.

“With months to spare before the stress tests, during 2014 the lower capitalised jurisdictions turned strongly to the equity capital markets in order to bolster their financial position,” said Chan. While on average 42% of all new capital raised since the last stress tests was raised this year, for some countries it was significantly more. Cyprus’s capital raising in 2014 accounted for 74%, Austria 71%, Greece 65% and Portugal 53%. Italy and Ireland were slightly below the average at 36% and 32%.

“Looking at the ratio of capital raised since 2011 relative to assets, the latest round of capital raisings have helped Greece reach 4%, Cyprus and Portugal 3%, Italy, Ireland and Austria 1%”

Yet, warns Chan, “new capital has not been raised evenly among those countries that needed it most”. Of the 66 banks based in the least capitalised jurisdictions** at the end of 2013, just over a quarter (25.7%) successfully raised capital in 2014, and even among this group, under half (47%) accounted for three quarters (75%) of all raisings, suggesting that some banks may yet suffer a capital shortfall,” he added.

“The stress tests are forcing banks to become better capitalised and in doing so the process is expected to help bring back confidence in the European banking system and, in time, ease lending”.

After the stress tests

Following publication of the stress test results, two key deadlines are expected to be imposed by the ECB. If shortfalls are identified in the AQR or baseline stress test scenario (using CET1 ratios), a bank will be allowed six months after announcement of the comprehensive assessment results to take remediation action. If shortfalls are identified in the adverse stress test scenario (using Additional Tier 1 (“AT1”) capital up to specified limits) a bank may consider whether it is appropriate to issue AT1 capital as an alternative to, or to complement, a rights issue or equity placing. For this, a bank will be allowed 9 months to take remediation action.

“The main options for a bank considering ECB-required remediation action or balance sheet strengthening are equity or other capital raising, liability management, deleveraging by loan portfolio sales, restructuring its business through separating core and non-core businesses and conducting asset sales, and retaining earnings”, said Chan.

“Remediation plans would need to be presented by the banks within 2 weeks of the results being confirmed for evaluation by the SSM, but the biggest challenge is likely to be the successful implementation of any remedial action in potentially busy, volatile markets which may limit the windows for successful capital issuance for example,” he added.

“Any bank unable to repair its financial position faces the prospect of regulatory intervention. Likely to focus initially on implementing recovery plans, this may escalate quickly to a point where the regulator must decide whether to use any statutory resolution tools to prevent the bank’s failure or, in a worst case scenario, allow it to go into insolvency,” he continued.

“For a bank unable to access market financing and requiring recapitalisation directly rather than indirectly through state support, the Direct Recapitalisation Instrument under the European Stability Mechanism financial backstop to the European Banking Union is expected to be operational when the ECB assumes its new role. However, this tool and public recapitalisations are expected to be required in exceptional circumstances and only if private sources are not available”.

Looking back to the last stress test of early 2011 a total of 8 banks (five Spanish, two Greek and one Austrian) failed the test. For three of them the stress test resulted in significant turnaround with capital raising and restructuring being implemented and culminating with improved positions between 2011 and 2013 of as much as five percentage points (to 11%) in the amount of CET 1  capital and significantly reduced their losses. The remaining five were either sold off or merged. 

For more information, contact Surinder Sian on 0207 456 4842 or 07827  

* Source: Dealogic, original 128 banks under review that are listed

** Source: Bloomberg, original 128 banks under review

*** Source: : ECB, NBER/NYU Stern