Vulnerability of European banks: research by Diane Pierret on the results of the stress test
On Friday 29 July, the European Banking Authority published the results of its stress test, which measures the level of resistance of eurozone banks to a potential shock. The results of comparative research conducted by Diane Pierret, professor of finance at HEC Lausanne (UNIL), in collaboration with professors Viral V. Acharya of the University of New York and Sascha Steffen of the University of Mannheim, give more cause for concern than those highlighted by the EBA.
According to the results announced by the EBA on 29 July, only one of the 51 banks which participated in the stress test needed to recapitalise: Banca Monte dei Paschi di Siena. In a departure from its previous practice, the EBA disclosed only the bank capitalisation ratios, without specifying the threshold below which a bank would be considered as vulnerable and insufficiently capitalised.
In their research titled "Introducing the "Leverage Ratio" in Assessing the Capital Adequacy of European Banks", published on 1 August 2016, Diane Pierret and her co-authors used two approaches which enabled them to assess the total recapitalisation requirement:
1. Applying the US prudential rules, 29 European banks would need to recapitalise, with the total shortfall amounting to E123 billion.
2. Using the SRISK index which measures the level of systemic risk and was developed by the CRML at HEC Lausanne-UNIL and Vlab at NYU Stern, the capital shortfall would be E675 billion (December 2015), for the 34 listed banks alone. It should be noted that the SRISK index is based on current market data, and increased by E207 billion between December 2015 and June 2016 (reflecting subsequent events such as Brexit), while the stress test relied on accounting data from December 2015.
Professor Pierret commented on the results: "It is a matter for concern that the market value of equity has diminished sharply compared to book value. This explains in particular the wide gap between the market assessment of the banks' shortfall in capitalisation and the measures used by the regulatory authorities. The negative market reaction to the publication of the results of the stress test reinforces the feeling of a disconnect between market expectations and the actions of the regulator"