A little less conversation, a little more perspective please

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A little less conversation, a little more perspective please

Analysts have been quick to hit out at Spain's bank stress test results last week, telling anyone who will listen that the 6% core tier one target under the stressed scenario will not give confidence. But the market should remember how far it has come on capital.

Banks and regulators have put serious work into increasing banks' capital since the financial crisis. Absolute ratios will be much higher than in the past. And the make-up of that base should mean that banks will be better able to absorb losses than they would have in their pre-crisis form.

At the same time, market pressures are adding to regulatory ones. The big lenders that implement Basel III according to the global regulator's timeline are likely to find themselves whipped by investors that want banks to be ready for anything, and that means being ready for 2018 regulations today.

This is a good thing. Market discipline should be pushing banks to become more stable, and quickly too. But the actual ratios also need to be taken with the proverbial grain of salt.

Spain's stress tests, released last week, were quickly tossed aside as lacking credibility. Investors and analysts said that a 6% core capital target ratio was simply too low. At that level, the banks would not be able to fund in wholesale markets, they said.

It's true that 6% sounds low against the 9% and 10% ratios that are more frequently bandied about as being desirable. But it is worth taking a step back for a moment.

The European Banking Authority's capital push, launched in the fourth quarter of last year, called for the continent’s largest banks to hold a 9% core capital ratio in a stressed situation. That bespoke measure does not quite tally with common equity capital, or tier one capital. Spain’s smaller banks were not subject to the capital exercise, and the larger banks outside state hands have met it.

Meanwhile, Spain's stress tests modelled capital ratios out to the end of 2014. By January 2015, all banks in jurisdictions signed up to Basel III will need to hold common equity capital of 4% and tier one capital equal to 1.5%, of risk weighted assets. Sure, the Spanish stress test only adds 50bp to that under the adverse assumptions. But is above the minimum required — not to mention above the pre-crisis capital levels at plenty of European banks.

Lenders in stronger jurisdictions are likely to have much higher capital ratios than that by the end of 2014. Their funding will be easier and cheaper as a result. But it is hard to defend the case that Europe should be spending valuable resources in capitalising Spain’s banks to a bullet-proof standard under a set of worst-case assumptions.

Frustration about stress tests perceived as being too soft may simply be an echo of similar grievances with the Spanish government’s piecemeal approach to fixing its banking sector since the crisis began. But it is important to maintain perspective. Capital is meant to be run down in times of stress, for a start. If bailed out banks hit the stringent new regulatory requirements even when accounting for a severe economic downturn, surely that should be enough?

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