Stressed from Tests

The European Central Bank published its annual comprehensive assessment results, including those from the Asset Quality Review and stress tests. 80% of EU banks passed with their Common Equity Tier 1 (CET1) ratio greater than 5.5%. Nine Italian banks, of the 25 in Europe, failed to meet the 5.5% minimum CET1. Although other mid tier banks in Portugal, Greece, and Cyprus also fell short, Italy emerged as the one with the poorest financial health. In response to the significant number of lenders in Italy who failed the ECB’s comprehensive assessment, traders may exert an upward pressure on Italian sovereign bond yields.

The tests cost hundreds of millions of euros, with the intention of restoring faith in European banks again. Despite the 80% pass rate, banks will continue to be reserved in their lending policies mainly due to their low credit demand. Alberto Gallo, analyst at Royal Bank of Scotland, predicts that European banks will keep tightening their lending, even after the €593bn loan reduction to companies since the crisis. The market also holds bearish sentiments regarding the financial sector, as the Euro Stoxx Banks Index closed down 1.7% after ECB’s health check results were posted.

Although the weak lending forecasts have gloomy implications towards Europe’s economic recovery, the European Central Bank’s stress tests and Asset Quality Reviews were not for naught. It required banks to improve their structures and will likely reduce the European banking sector’s 11% implied cost of capital. While the ECB’s new regulations only produced lukewarm results, they can be argued as necessary steps toward ensuring the efficacy of financial institutions.

-- Angela Weiqian Li