Ready, Steady, Stress! Capital Structure Investing in a Changing Eurozone Banking Landscape

We believe the ECB’s stress test will ultimately benefit many investors across the bank capital structure.


The European Central Bank is just days away from announcing the findings of its asset quality review (AQR) and stress test for the 130 biggest banks in Europe, and the markets are eagerly anticipating the results. Below, managing director and global head of financial research Philippe Bodereau answers frequently asked questions about the ECB’s stress test, and discusses where PIMCO sees value within bank capital structures.

Q: How do you expect the AQR and stress test will affect European banks?
Bodereau: We believe the AQR/stress test will be a cathartic experience for European banks and a positive milestone in their recovery story. We expect it will ultimately benefit investors across the bank capital structure, and for debt investors in particular, it is undoubtedly a positive stepping stone. I will address specifically what investors should expect from the 26 October results release, but before that, let me take a step back and look at the big picture.

After years of procrastination that have in no small part contributed to its subpar economic recovery, the eurozone has finally gotten serious about cleaning up the weakest segments of its banking system. Eurozone economies and citizens have paid a high price for these delays, but better late than never. Regardless of what happens next Sunday – and I am sure that we will find plenty to criticise in the process, assumptions and outcomes – the AQR/stress test has already been a success.

How? First, because it is the first genuine attempt to significantly dilute national authorities’ ability to exert regulatory protectionism in order to avoid restructurings and recapitalisations. The widespread lack of willingness among national regulators to confront their own banks’ cyclical and/or structural weaknesses has led to the “zombification” of large segments of the eurozone banking system. This is not limited to peripheral banking systems, as the current state of German and Austrian banks demonstrates. With the stress test, and with the ECB taking over as lead bank regulator in early November as part of the single supervisory mechanism (SSM), hiding issues will become much more difficult.

Second, since the AQR process kicked off a year ago, the fear of the new ECB sheriff has forced a number of banks to pre-emptively strengthen their balance sheets (see Figure 1). Just looking at the larger banks under our coverage, we estimate that €79 billion has been raised in a combination of equity and contingent convertible (CoCo) issuance, in addition to significant top-ups in provisions.


Third, the exercise has significant educational and informational value for investors. One should not underestimate the ambition of the AQR, a year-long process during which regulators, auditors and consultants have scrubbed through millions of loan files. At the very least, it will bring much more transparency to the market and a better ability to assess the true state of asset quality in eurozone banks. For instance, various accounting standards and tax regimes have led to significant differences in how to classify nonperforming loans and in the way provisions should be taken. While full harmonisation is some way off, the AQR should bring a more consistent and comparable snapshot.

Fourth, we hope the completion of the AQR will lead to a new round of consolidation and rationalisation in the most inefficient and overbanked systems in Europe, namely Germany and Italy, two countries that should emulate the impressive structural reforms of the Spanish banking industry.

Q: Do you expect many banks to fail the test?
Bodereau: We have spent considerable time and resources reverse-engineering the ECB stress test. In our numbers, out of the 130 banks under review, we have a high conviction that over half will pass with strong marks, comfortably above the 5.5% common equity T1 threshold (see Figure 2). In particular, we expect all large systemic national champions will pass the stress test.


At the other end of the quality spectrum, we have identified 18 banks that will likely fail the stress test and will therefore need to be recapitalised, restructured, sold or resolved. These tend to be relatively small banks in terms of balance sheet size, mostly in the cooperative and semipublic sector in Germany and Austria, plus several of the weakest regional banks in the periphery. Many of these banks failed during the 2008 financial shock or during the eurozone crisis and are already undergoing restructuring plans.

Perhaps most interesting is the “narrow pass/narrow fail” category, which makes up about a third of the banks under review. While we do not expect these banks will be required to launch large scale rights issues, they will be under pressure to adopt conservative balance sheet management and prudent dividend policies for a number of years.

Q: Do you worry that banks “failing” the stress test will be subjected to significant price volatility? Could this lead to potential creditor bail-ins?
Bodereau: The AQR will likely generate volatility and dispersion in bank stocks, primarily because lumpy provisioning top-ups will hurt tangible book values, and therefore key stock valuation metrics.

For creditors, we view the exercise as overwhelmingly positive because it is a catalyst for balance sheet clean-up and improving capital ratios. The critical question for creditors, in particular subordinated bondholders, is less to identify who will pass or fail the stress test than to understand who will pay for a potential capital shortfall.

Once a bank has failed the stress test, it will have a couple of weeks to submit remedial actions to the ECB and up to nine months to execute its plan. For most banks in this position, we expect private sector solutions will be available through a combination of capital raising, deleveraging and/or asset disposals.

In the unlikely event that a private solution is not available to a bank, either because the bank is unlisted (cooperatives, mutuals) or has lost access to the equity market, the ECB and European Commission rule book is clear: As tested in the recent resolutions of SNS Bank or Banco Espírito Santo (BES), shareholders will be wiped out and subordinated debt instruments will be subjected to severe haircuts before any taxpayer money is deployed. However, ECB President Mario Draghi has explicitly confirmed that senior debt bail-ins were ruled out for the 2014 stress test.

Q: Market volatility increased over the last quarter with risk asset classes, including capital securities, selling off. What are the main drivers of this weakness?
Bodereau: Nervousness about the AQR/stress test has not played a major role in this selloff. The key driver has been the broader risk-off sentiment, and the past few months have not been short of bad news on the macro (concerns over Federal Reserve policy, disappointing eurozone GDP numbers) and geopolitical fronts (Russia, the Middle East). This has led to a significant correction in the pricing of bank equities, high yield, commodities and, more recently, the highest-beta government bonds such as those of Greece, which dropped nine points last week (see Figure 3). In addition, idiosyncratic events such as the failure of BES and subsequent price default of its lower-T2 debt have been a wake-up call to bank credit investors who had grown overly complacent about outer peripheral assets.


The price action in bank capital has not been homogenous, however. The highest-beta additional T1 (AT1) instruments have sold off hardest, with prices five to 10 points down since the mid-June market peak, and price action has been amplified by large, aggressively priced and poorly executed new issues in September. Meanwhile, T2 CoCos and legacy T1s have held up much better and experienced a fraction of that volatility.

Q: Where do you see value in bank capital structures, and what’s your expectation in terms of returns for capital securities?
Bodereau: The most critical point is that our fundamental thesis is intact. The banking industry is undergoing a generational and super-secular paradigm shift that is leading to smaller, much better capitalised and highly liquid balance sheets. Regulatory pressure – whether in the form of stress tests, new leverage ratios or national gold platings of capital rules – remains intense. This is particularly true in the UK, the US and Switzerland – the three banking systems we currently favour. With the eurozone finally catching up, capital ratios of Western banks have roughly doubled and currently stand at decades-high levels.

In addition, with a few notable exceptions, we are getting to a point of the banking cycle where a vast majority of legacy losses have been recognised. The AQR will, in our view, efficiently identify the remaining areas of weakness. Six years after the collapse of Lehman Brothers, two and a half years after Greece’s debt restructuring and following intense deleveraging and balance sheet shrinkage, Western banks are just running out of ways to lose money.

Another important investment consideration is that AT1s and CoCos of the strongest eurozone banks will be direct beneficiaries of the ECB’s incremental easing of its monetary policy via unconventional measures. In particular, we expect the second longer-term refinancing operations (TLTRO) auction in December will attract substantial demand and will anchor senior debt valuations at tight levels. Over time, this should feed through the lower parts of the capital structure. Finally, we believe the ECB’s quantitative easing, which we expect in early 2015, will also be a positive catalyst.

In addition, subordination premia remain historically high and valuations across the capital structure are heavily dislocated, offering exciting relative value and capital structure arbitrage opportunities (see Figure 4). While bank hybrids can be a challenging and volatile asset class, current yields ranging from 6%–8% with an option adjusted spread of around 429 basis points for the strongest EU banks offer a compelling entry point (see Figure 5).



The Author

Philippe Bodereau

Portfolio Manager, Global Head of Financial Research

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