What did the ECB stress test show about the state of banks in our country?

Let's be honest: the way the Bulgarian media covered the latest stress test and conveyed the information presented by the ECB in the official press release was contradictory. The articles in some media were of the type "The stress test showed that the banking system is stable", while the text itself contradicted the headline by saying that the ECB had found problems in some banks. The BNB's statement on the subject did not help either. In the end - are Bulgarian banks stable or not? What does the ECB say? Is there any need for concern?

The stress test was conducted on six banks. The three largest with foreign ownership, respectively UniCredit Bulbank, DSK, United Bulgarian Bank, and the three largest with Bulgarian ownership – First Investment Bank, Investbank and Central Cooperative Bank. Are they all stable? No. ECB data clearly shows that two of them have problems. In this article I will try to explain as much as possible in detail and simply 1) what the ECB stress test is and 2) what its results showed, in order to clear up all the ambiguities and misconceptions that have been circulating in recent days.

What is the latest ECB stress test?

To continue, however, we need to clear up some definitions.

First of all, what does "asset quality review" ( abbreviated " AQR") mean? Before even talking about stress tests, the ECB first conducts such a review. This, in simple terms, means assessing the level of credit risk associated with a specific asset of the bank, for example a mortgage loan. The main banking activity of granting loans at a fundamental level is a risky activity. Each client of the bank and the corresponding asset (credit product) associated with it has a certain level of risk. The ECB's goal is to make an objective assessment of the level of risk associated with all assets, and accordingly all clients of the bank. That is, it assesses the probability that a client will stop paying its obligations and, accordingly, the assets associated with it will turn out to be non-performing.

This is the next key term. Non-performing assets are those assets that do not bring the bank's expected cash flow, which is a consequence of the respective clients being in a situation of temporary or permanent insolvency.

The third key and most important indicator is the so-called "common equity tier 1" ("common equity tier 1"), which in English is denoted by the abbreviation CET1. This is a very specific category of equity, which was formulated and defined after the global financial crisis in 2008 and began to play a key role in assessing the financial condition of every bank around the world. This CET1 category includes the core capital of a given bank - common stock, retained earnings and other accumulated available income. In simple terms - these are those assets that are 100% equity of the bank and are not owed to external companies or individuals.

What is the importance of CET1 core capital?

This brings us to the first stage of the ECB's assessment of the soundness of banks. This core capital CET1 is related to the bank's risk-weighted assets, which risk weighting is carried out after the asset quality review (AQR). Each asset is "weighted" according to its level of risk, i.e. the riskier it is, the greater its weight in the CET1 capital.

The ratio of CET1 to risk-weighted assets is the key indicator of the financial stability of a bank. As you might guess, it shows us what proportion of risky assets are covered by CET1 capital. The higher the ratio of CET1 to risk-weighted assets, the more stable the bank. This is what is colloquially called the "capital adequacy level". In the table below you can see what are the minimum levels of CET1 to risk-weighted assets ratio required by the ECB.

What does the asset quality review show?

In principle, this part of the stress test is not expected to receive much attention, because it is assumed that after the asset quality review, no obvious problems will immediately emerge in a bank. It is a preparation for the hypothetical stress test scenarios, where problems, if any, are expected to become apparent. However, this is not the case in this case, because it turns out that even after the asset quality assessment, First Investment Bank does not meet the minimum requirement for the ratio of core capital CET1 to risk-weighted assets. That is, even before any hypothetical economic scenarios are applied to the bank's finances.

The minimum requirement for the SET1 ratio is 8.0%. After the asset quality review at FIB, it turns out that this level is 4.5%. Much lower. At Investbank, after the asset quality review, this ratio is close to the limit - 10% - but still remains above it. Thus, FIB turns out to be the only one of the six banks that fails at the most basic stage of the stress test. This is not a good sign, because in practice it means that even at the present moment, without talking about any hypothetical future scenarios, FIB suffers from a shortage of core capital, according to the ECB requirements. For comparison, at the other banks subject to the stress test, the level of capital adequacy by this indicator is 4-5 times higher. At CCB, UBB, DSK and Unicredit, after the asset quality review, the level of the SET1 ratio varies between 16.2% and 23.1%.

What does the infamous stress test show?

The stress tests themselves are an assessment of how a bank's finances would perform if recent economic trends persisted or worsened. The stress test that the ECB conducted included two hypothetical scenarios. One of the ambiguities with this particular stress test is that it does not have a separate published methodology, and according to the ECB's press release, it is based on the methodology of the stress test that was conducted for the entire Eurozone banking system in 2018. Under this methodology, the first of the hypothetical scenarios is the so-called "baseline" scenario, which, broadly speaking, is an extrapolation of economic trends from the recent past (several years) for the next few years (in this case, 3). The second hypothetical scenario is "severe". It assumes that the economy is in recession, there is a cumulative decline in GDP of 2.7% within 3 years, property prices collapse by nearly 20% in 3 years, and unemployment almost doubles within the same period.

Table 2: Evolution of CET1 ratios and resulting capital needs

Source: ECB

Above you can see the ECB table with the results of the asset quality assessment and stress tests. Look at it carefully. I have circled in red those levels of the SET1 ratios that are below the ECB requirement for the respective scenario. In the fourth row with the three red circles is Fibank, and in the last row with the two red circles is Investbank. In the last column, the ECB indicates how much the core capital shortfall is in the respective bank (in euros) after the asset quality assessment and stress test. As you can see, there is no shortfall in all banks except Fibank and Investbank.

These data show that UniCredit, DSK, UBB and CCB pass the stress test successfully, including in the "aggravated" scenario, without suffering from a capital shortfall. The requirement is that in the "aggravated" scenario of the stress test, the ratio of SET1 to risk-weighted assets should be at least 5.5%. All of the banks listed above meet it. However, at FIB and Investbank, this ratio turns out to be negative, -2.0% and -3.1% respectively. At FIB, a capital shortfall of EUR 262.9 million appears, and at Investbank EUR 51.8 million. In the baseline scenario, the minimum requirement for the SET1 ratio is 8%. FIB and Investbank achieve 4.1% and 5.7% respectively, therefore they do not meet the capital adequacy requirement in both the baseline and the aggravated scenarios of this stress test.

What does this mean? It means that in the event of a financial crisis (especially if it is as severe as the one in 2008/2009), these two banks face a serious risk of liquidity shortages and therefore face a higher risk of bankruptcy. Many "experts" are afraid to say this outright, but in reality this is the whole point of these stress tests - to understand what will happen to banks in a situation of economic crisis. This particular stress test shows that, given their current financial situation, FIB and Investbank would experience financial difficulties in the event of a recession. This does not mean that they will definitely go bankrupt if we enter a recession. It only means that there is a risk of this happening. Much more significant than with the other 4 banks subject to the stress test.

What do the rest of the ECB data show?

Even more interesting are the ECB data on banks’ exposure to non-performing assets. As I mentioned above, this shows how much of the banks’ assets are not being serviced by clients according to the contractual terms and, accordingly, do not bring the expected cash flow. In the case of Fibank, before the asset quality assessment, this level (at the end of 2018) was 19.1%. After the ECB’s asset review, it is already 44.1%. The detailed breakdown shows that problem assets are concentrated in the bank’s corporate portfolio. In retail loans (which include individuals and small and medium-sized enterprises), the level of non-performing assets is 14.6%. However, in the corporate portfolio (i.e., in lending to large companies), this level is already 56.2%.

In Investbank, the overall level of non-performing loans is 35.0%, slightly higher than the baseline of 29.5% before the ECB assessment. Here, bad assets are more evenly distributed. In the corporate portfolio, the level is 36.2%, and in the retail portfolio it is 32.7%. Of the other four banks, none has similar levels of non-performing assets. In Unicredit after the ECB assessment, the level is 8.8% overall, in DSK it is 11.4%, in UBB it is 13.5%, and in CCB it is 16.8%. It should be noted here that according to the ECB, Fibank's provisions for non-performing assets cover their level of 67.8%, and Investbank's provisions cover 55.4%. But the very fact that the level of "bad" assets is so high in these two banks, and many times higher than in any of the others, is curious.

It is curious what is the reason for these high levels of "problem" assets? I cannot give a definitive answer here, because there is not enough detailed data available. As for these two banks, I have come across speculation that they have problem assets because they lend to related parties and companies that are losing money. I cannot comment on whether these speculations are true or not, but it is a fact that FIB was fined by the Bulgarian National Bank for an unauthorized loan to a co-owner of the bank at the end of last year. On the other hand, these high levels of problem assets may be the result of errors in the bank's credit policy. In any case, in addition to these, the ECB presents other interesting data. You can find the ECB's data for each of the six banks here.

Conclusion

I hope that in this article I was able to explain as clearly as possible 1) what the latest ECB stress test is and 2) what this stress test showed about the condition of the six banks under consideration. I recall that three of the banks (Unicredit, DSK, and UBB) are the largest banks in the country (by asset value), which are subsidiaries of foreign banks, and the other three (Fibank, Investbank, and CCB) are the three largest Bulgarian banks. Fibank is the fourth largest bank in the country overall. The fact that, according to the ECB, it has problems with capital adequacy even after the asset quality review is not encouraging. It is unlikely that the ECB would allow Bulgaria to enter the Eurozone before the problems in Fibank and Investbank are eliminated. In recent days, these two banks have issued statements on the topic, with Fibank saying that it already has half of the necessary capital buffers to meet the ECB's requirements, and Investbank also saying that they will strengthen their capital adequacy through conservative banking policy.

Otherwise, how good the idea of entering the Eurozone is for Bulgaria is a completely different topic, which we have actively commented on and continue to comment on. In this case, the important thing is that the stability of the banking system is a key factor for our admission to the Eurozone. In view of the problems in the banking systems of some current Eurozone member states (such as Italy), the ECB would not want to introduce another problem into a banking system that has poorly capitalized large banks. You already know what the ECB stress test showed. I shared my reading of these data. You can also look at them and judge for yourself. Always try to form your own opinion based on clear facts. Because this topic has shown that the media cannot always be relied on to accurately convey the information presented.

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