"Stress-testing Eastern Europe
Well, not Eastern Europe per se, but Western banks’ exposure to the region.
Merrill Lynch’s Global Economics team has done a bit of analysis (emphasis FT Alphaville’s):
A simplistic stress test on Emerging European exposure at listed Western European banks shows the potential for an incremental €13bn of losses. We assume this will be spread over several years. In the context of a sector expected to generate €56bn of 2009 profits, Emerging European losses are not, by themselves, devastating.
What’s that? Good news? Not quite.
What the market giveth with one hand, it taketh away with the other, as Merrill Lynch note:
However, we highlight that Emerging European exposure is simply one of many potential problems facing Western European banks. Taken in combination with deteriorating conditions in Western Europe, incremental capital commitments owing to the pro-cyclicality of Basel II, significant off-balance sheet commitments, and earnings headwinds from de-levering, we continue to think investors should take a cautious approach to Western European bank equity.
As for the stress test criteria, Merrill’s assuming Western banks have €1070bn of exposure to emerging Europe, or roughly 3 per cent of total assets.
However, some banks are more exposed than others. All of Raiffeisen International’s loan book, for instance, is in emerging Europe, while 39 per cent of Erste Bank’s is. Of the 17 banks in Merrill’s analysis, 11 have more than 10 per cent of their loan book in the region.
Here are the test specifics:
We think it is worth noting that our stress test only assumes that Emerging European provisions rise. We make no changes to our forecast of pre-provision profits, nor do we assume that elevated risk in Emerging Europe has a negative impact on profitability in Western Europe. Further, we have not written down equity owing to currency devaluations. In this way, our stress test is admittedly simple and understates losses in a full-blown emerging market crisis.
After estimating an NPL level for each country, based on assumptions about macroeconomic NPLs varying with the degree of crisis, we assume cumulative losses equivalent to 50% of NPLs. We then compare the implied provisions from this stress test with the cumulative provisions already factored into our base-case forecasts for each bank for 2009-2011E. We have made several assumptions in this methodology, and we emphasise that the exercise is intended as a scenario analysis, rather than a base-case forecast for how the current emerging market crisis will unfold. Estimating the appropriate level of NPLs for each scenario is one of the key sensitivities in our analysis.
The results of the stress test are in the first table below. The assumed level of NPLs (non-performing loans) in the second, ranging from an “IMF-scale crisis” to a simple “Macro slowdown”. (Click to enlarge)
On average then, the stress test scenario moves the banks’ core tier 1 ratio, the key regulatory measure of banks’ capital position, from 6.9 per cent to 6.4 per cent — hardly a dire level from a regulatory perspective. But, we should note below Merrill’s own definition of a “well capitalised” bank…
In any case the really interesting thing here, as Merrill says, is the relationship between country risk and bank risk, which may be changing:
We see continued stress for parent banks in the near term as they grapple with significant goodwill write-downs, higher loan loss provisions, and the translation effects of volatile currencies. In addition, it appears that many of the major European banks have been active in making funding available to their pressured CEE subsidiaries (which is generally consolidated so less visible to investors, but exceeds US$400bn to be repaid this year alone), adding to the risk if transfer risks materialise as currencies are frozen and/or debt moratoria are imposed.
As is the case for Western Europe, we are in the process of an unprecedented level of credit substitution in the region, whereby sovereign risk is substituted for individual bank risk, though with parent company credit metrics disintegrating in some cases faster than the CEE subsidiaries, credit markets have needed to look beyond immediate parent credit strength for the ‘second way out’. So far, such has been the virulence of the banking crisis that all credit substitution has achieved is to infect the credit quality of the supporting sovereign, while having little impact on the underlying risk premiums of the supported bank.
Our sense is that the credit market is moving on from concerns with respect to non-payment or non-redemption of bonds (the most obvious form of default) to a consideration of the various forms of debt forgiveness that might be in the offing – for example, debt exchanges or debt-for-equity swaps. We are just beginning to see these emerge in Western Europe as a tool for dealing with banking sector insolvency. Indeed, with cash prices for bonds so distressed, it seems increasingly less likely that indebtedness will be serviced and redeemed in a timely manner, in our view.
In otherwords, moderately good news for Eastern European countries themselves, somewhat more ominous for Western European banks with Eastern exposure.
UBS: No Eastern European meltdown - FT Alphaville
CEE’s western exposure - FT Alphaville
UniCredit’s eastern exposure - FT Alphaville
Mar 10 03:51
I've suggested on Buiter's blog that we should simply move on and discuss whether a form of default is better or inflation is better. It sounds like default is the choice, which I thought was easier to deal with, if I'm not mistaken. I'd be surprised if we don't have some form of default as a solution to this crisis.