UK banking faces higher levels of capital depletion than Europe

A bank stress test is an analysis conducted under hypothetical economic scenarios, including a deep recession or financial crisis, in order to see if a financial entity holds enough capital to withstand the impact of such adverse developments. In 2018, the European Banking Authority (EBA) carried out a series of stress tests across the continent’s banking sector in preparation for a tumultuous period – with Brexit and a number of political crises continuing to trouble the social and economic stability of the European project.

Late in 2018, the analysis of 48 banks by the EBA has been published, and at first glance, the Stress Test 2018 results make for comforting reading for large European banks. They mention no incremental capital needs, while most banks demonstrate strong resilience to weather a stress test. However, a detailed breakdown by global consultancy Alvarez & Marsal has gone on to show that there are more losers than winners, with most banks unable to fit their business models to generate adequate levels of efficiency and returns within new regulatory constraints.

Alvarez & Marsal’s report shows that, overall, UK banks are the biggest losers of the Stress Test 2018. Common Equity Tier 1 (CET1) is a component of Tier 1 capital that consists mostly of common stock held by a bank or other financial institution. The stress testing showed that the UK exhibits the highest level of CET1 Fully Loaded depletion (-599bps vs. EU average of -394bps) and the lowest capital flexibility post-stress against a 5.5% minimum threshold.

At the same time, all of the UK banks surveyed by the EBA displayed higher depletion than in 2016, with the exception of the Royal Bank of Scotland (RBS). According to the research from Alvarez & Marsal, these results have largely been driven by a harsh UK scenario, with the Stress Test depicting a Hard Brexit. While a few months ago, this was still being scoffed at as an unlikely scenario, just three months before the finalisation of Brexit it suddenly seems a likely outcome – potentially spelling major problems for the UK banking sector.

However, UK banks are capitalised above EU averages, and according to the analysis, their profitability is projected under baseline as double their EU counterparts. This is largely because they deal with just half the non-performing loan (NPL) ratio the EU averages. While it might be naïve to suggest this gifts UK banks insulation from any coming storm, it does mean that EU banks should not be sitting comfortably either, as they are not necessarily less exposed to a crisis than UK banks.

Summarising the findings, Alvarez & Marsal suggested that the European banking system is largely healthily capitalised, and can weather stresses, but thanks to regulatory constraints, fails to meet investor demands for higher returns. According to the firm, banks can improve on this front by improving business profitability through stricter capital allocation and pricing, the sale of unprofitable businesses and a concentration on core activities that drive acceptable returns.

In conclusion, Alvarez & Marsal Partner Fernando de La Mora, who authored the firm’s analysis, said, “While there is welcome good news on the capital front, 2018 stress test results continue to show an industry that struggles to perform under new regulatory constraints. Bank performance scorecards show major efficiency and profitability gaps that explain lagging stock price valuations.”