The Impact of Government Default on European Banks

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It is important to know what would be the effect of eventual government default. Reuters Breakingviews has created stress test calculator for estimating what possible implications to Euro banks and governments in such case would be.

Recently conducted stress test of European banking system in July has been widely criticized. Often stated was the fact that requirements in the test were lowered, which question credibility of the test. According to the results most of the EU lenders had enough capital to sustain tough economic conditions. The problem is that minimum capital requirement in the test conducted by EBA (European Banking Authority) was 5%, far low below EBA’s current 7% threshold. Moreover after latest painful developments European banking regulator has discussed option for rising capital requirement to 9% as additional buffer. Another pitfall of the test is that includes only half of EU banks and excludes smaller ones.

The Breakingviews Euro Zone bank stress test aims to be more stricter than previously conducted. There are some details to be considered when reading the output. As described in the test notes it uses the same data as EBA. Results show how many banks would fail, which of them will suffer most, what amount capital is needed to cover core Tier 1 ratio and the impact of the recapitalization on each Eurozone country’s debt. General assumption is that calculations are made with 12 Oct market prices for 5 year bonds.

If we consider 63% Greek bonds haircut and 40% Portugal with 7% Tier 1 capital threshold, then capital shortfall would be €95.6B. Most of the burden has to be taken from Greece as €31.9B must be raised, Spain - €15B, Germany - €13.8B. In this case most vulnerable are Greek banks: NBG, Eurobank EFG, ATE Bank, Piraeus, Italian Unicredit, German Commerzbank and Deutsche Bank.

Euro zone stress test with Greek and Portugal haircuts

If we assume worst case scenario with Spanish and Italian haircuts of 30% (added to Greek and Portugal) and implementation of 9% core Tier 1 ratio, the picture looks ugly. Banks considering significant capital shortfall are – Unicredit, RBS, BNP Pariba, Santander, Banco Bilbao, Deutsche Bank, Commerzbank. Capital shortfall is close to €400B. In this case Spain must raise additional €104B, Italy - €58B, Germany - €53B, France - €53B, UK - €45B. Unfortunately in such conditions credit markets are practically paralyzed and funding is impossible. Where does money come from? The European Financial Stability Facility (EFSF) was designed to help stressed EU countries. With latest approval for increase of its funds to €780B there should be some relief that even worst case scenario is manageable.

Euro zone stress test with Spain and Italy haircuts

After the both tests conclusion is that there are certain banks considered to bear additional risk of capital shortfall in extreme conditions. Countries with highest recapitalization level (cost of recapitalization/GDP) are Greece, Cyprus, Portugal, Spain, and to lesser extent Germany, France, UK, Italy. In real terms, however, Spain, Germany, France, UK have greater impact of recapitalization related to total shortfall. It is clear that problems are not lack of funds but rather lack of decisions i.e. political willingness for quick resolving of the crisis.

You could perform your own stress test here!