Tuesday, November 3, 2015

ECB Stress Test - A Tale For Laymen

Two detailed analyses of the recent ECB stress test of the 4 large Greek banks were published in Macropolis and Forbes. I will try to make them understandable for laymen.

The ECB assumed an adverse macroeconomic scenario for the period 2015-17 and checked its impact on the health of the 4 large Greek banks. The adverse macroeconomic scenario assumed a cumulative GDP decline of 7% and a cumulative decline in housing prices of 22%. One would think rather pessimistic assumptions! In that scenario, the 4 banks would require additional equity (capital) of 14,4 BEUR (which will bring the total equity of the 4 banks to about 30 BEUR) in order to remain sound. One remembers that the Eurogroup had originally 'reserved' 25 BEUR for the bank recapitalizations. 14,4 BEUR is a lot less than that. So everything is very fine? Absolutely not!

Picture yourself as the personally liable sole owner of your own private bank. Your bank has assets, liabilities and equity. 'Assets' are what you own (loans, securities, etc.); 'liabilities' are what you owe (deposits, other funding) and 'equity' is what you are worth if you could liquidate assets and liabilities at their book values. Assume that you have assets of 100 and liabilities of 90, which leaves you with a worth of 10 (equity). One day you discover that some of your loans are about to go sour and you calculate that your total assets are now only worth 90 and not 100. You calculate that your assets of 90 will serve to pay back your liabilities of 90 but - your own worth has been wiped out.

The above 14,4 BEUR equity requirement means that the 4 banks need an additional 14,4 BEUR of  equity to withstand the 2015-17 storm (i. e. losses) and still have satisfactory equity at the end of the period.

A bank is as healthy as the quality of its loans. If the loans are good quality, they are called 'performing'. If they are not, they are called 'non-performing'. 'Non-performing' means that the loans are not being serviced according to the original contract (a restructuring of maturities may have become necessary due to financial problems of the borrower, etc.). 'Non-performing' does not mean that the bank will lose money on the loans. It can, however, mean that the bank will end up with a total loss.

Take an oil company which calculates that it will be hugely profitable when the price of oil is 100 USD, that it will only break-even when that price goes down to 50 USD and that it will survive only another 3 months if that price goes to 30 USD. Today, oil trades at 50 USD and the company is breaking even. It had to restructure its bank loans and is now classified as non-performing. Tomorrow, oil shoots up to 100 USD and the loan becomes one of the best the bank has. Day-after-tomorrow, oil collapses to 30 USD and stays there, and 3 months later the bank will have a total loss.

Why a total loss when the bank is well secured with oil rigs as collateral? Well, ask yourself how much someone will pay for an oil rig when the entire industry is collapsing!

The 4 banks now have 107 BEUR of non-perfoming loans. To put this into perspective: that is almost half of all the loans they have (48,6% to be exact)! Where are the days when I read that non-performing loans were about 70 BEUR or about 35% of total loans? Not too long ago, I am afraid!

It's not only the sheer magnitude of non-performing loans which is frightening. Non-perfoming loans require intensive care on the part of the banks. When almost half of their loans require intensive care, one wonders when they have time and spirits to think about making good new loans!

The layman may wonder how a bank can stay in business when half of its loans are non-perfoming, i. e. do not earn any interest. The layman is naive! Many of these non-performers do earn interest, interest which the borrower pays with new money which the bank lends him. Think about that! (Sounds a bit like the 'rescue loans for Greece', doesn't it?).

The ECB reviewed the value of collateral which the banks have and they investigated 11.826 cases with a total collateral value of 21,4 BEUR. Wait! Only 21,4 BEUR? Compared with non-performing loans of 107 BEUR? Compared with total loans nearly twice that amount? My sense is that those non-performing loans will create huge losses not yet accounted for should the banks ever have to liqudidate collateral. Thus, one is basically condemned to viewing all these non-performing borrowers as ongoing concerns because if one didn't, the banks themselves would soon cease to be ongoing concerns.

Finally, I cannot save the layman from learning about an item called Deferred Tax Asset (DTA). As the name implies, that is an asset; something which the bank owns. To refer to the above private banker: DTAs are part of the 100 of assets which have 90 liabilities against them and which create a worth for the owner of 10.

What is a DTA? The above private banker might explain it as follows: "Look, I just took a huge one-time loss on a deal. The good news is that I can carry forward, for tax purposes, that loss into future years and deduct it from future taxable income. That way, I won't have to pay income taxes for several years and the DTA is today's calculated value of future income taxes which don't have to be paid. What if I do not have taxable income in the future, you may ask? Well, then the DTA is worthless"

The 4 banks have combined DTAs of about 15 BEUR. Hold tight and do the numbers: that is almost half of the combined equity of those banks! If those DTAs became worthless, the entire current recapitalization of 14,4 BEUR would go out the window, and more!

The Greek government, taking a cue from Italy, recognized this problem and copied Italy's (and other countries') creative solution: the Greek state simply guaranteed 82% of those DTAs, or almost 13 BEUR, to make it count against equity. To return to the above private banker: the owner could easily increase his equity by 100 BEUR. All he would have to do is have his bank lend him 100 BEUR so that he can put this money back into the bank as equity (regulations would not allow this to happen!).

This is conceptually similar to what's happening with the DTAs: the Greek state puts equity into the bank so that the bank can make it a loan to finance the equity increase. Well, only conceptually. In practice, the sequence is in reserve: it began with the DTAs which turned into a claim against the state when the state guaranteed them.

So what are these guaranteed DTAs of almost 13 BEUR really worth? Well, they are worth 100% according to Basel-3 and confirmed by the ECB. However, should they one day become worthless because the Greek state fails, then the banks will follow right behind the state!

And that is probably the key conclusion of the ECB stress tests: the Greek state and the 4 banks are now more linked with one another than ever before. Letting the state fail would lead to a collapse of the banks, and vice versa if one were to let the banks fail. The Greek banks will survive as long as the Eurogroup supports the Greek state. Understanding that is probably the most important outcome from the ECB stress test.

PS: 'Greek banks surving' does not necessarily rule out a future bail-in for depositors. If the recapitalization were not to take place before year-end, for whatever reason, the likelihood of such a bail-in would increase dramatically.


  1. Dear Klaus,

    your article should be translated into Greek and posted as Pflichtlektuere into Greek fora, where the prevailing opinion is that the "foreign interests are about to take over the Greek Banks on the cheap". And where the Government, all parties, the wider population and even some bankers (Piraeus' Sallas) vehemently object to any action by the Banks on real estate collateral (foreclosure, repossession, or whatever action to extract some value from the non-performing mortgages).

    The latest recapitalization is not going to be the last one!


  2. Thank you Mr. Kastner for translating for the Laymen,

    It is really complex when you take all the issues which will affect those banks livelyhood. Such as the homeowner nonperformer loans and how they will handle it. And is why i assume the quartreto is pushing for larger % of foreclosures as so these banks "gain" more "assets." Or the issue of the nonperforming loans of the media owed to banks roughly 1 billion, which the government is discussing the issuance of new liscenses and what to happen to the old loans? And finally 2 huge super market chains in greece which are also terribly non perfoming and normally should go bankrupt but are somehow staying afloat. But it is not dare mentioned in the media but the whole country knows in what dier straits these busineses are in.

    Yes, it looks grim. I am sure as KK mentioned there will be more recaptilzations. I also do not expect capital controls to be lifted as they have said at the start of next year, even though i trust Stournaras words. I highly doubt that. I also am a believer, deep down that there will be a bail in and is why there is so much propoganda to bring back your money out of homes and foreign banks without any charges of tax evasion. I try to lie to myself sometimes that the little money i have at home soon i will return it to the bank. To achieve some normality as to keep my sanity.

    Meanwhile please elaborate of some news that i read somewhere on an new agreement between USA, Germany, UK and other big nations that after 2015 no banks will be bailout but only bail ins. And is why they are running to bail out greek banks before the end of the year.

    What all the above equates to me is alot of pain. Really alot of pain. I have refrained from following news as in the end i will lose my mind. On occasion i come here and find some positive aspects artciles you may write. Truly how do you have the stamina to follow this Greek issue for so many years. I admire your courage and strength. I feel like humanity has lost its sense of humanity.


    1. The link below will lead you to a lot of information about the EU regulations governing bank bail-in's. If the Greek banks are not recapitalized before year-end, they will fall under those regulations and a bail-in of funders and depositors will not be possible to avoid.


    2. Thank You mr. Kastner,

      But Bail In and Bail Out, whichever it is the common citizen will need to pay out. Whether it be through taxes to bail out a bank or a bail in the depositor will pay immediately from his hard earnings saved. The difference in the two is simply that in Bail Out, in the EU, i assume the sum is spread across all eu citizens. Whetheras Bail In it is localized.

      Ingenious. As a banker having a bail in allows you to continue bad practices of the past and have the ability to simply take depositors money. On the other hand, it is in the banks best interest to have good working practice mentality, as to acquire deposits and have the depositors feel safe with their money in their banks. Which of the two paths do you believe modern bankers will take.


      I have long lost trust in the banking system. It feels like a dream, when i was a kid in the USA going to the bank excitedly to deposit my small earnings and seeing it grow slowly. That is all gone. I have no trust and is why i try to wisely spend any extra funds i have on smart projects.


    3. Regarding your second paragraph, standard practice in the distant past was that if a company or bank needed to be bailed-out or bailed-in, their managements had to go. For the very reasons you mention. What we have since since 2008 is that managements were replaced in only very few situations and then only half-heartedly.

  3. A great article, and in so few words. In my view the adjustment program will not be implemented and the red loan problem not resolved. That means there will be another re-capitalization, the question is only, in EUR or Drachmes?

    1. Lennard,

      The drachma question will never be realized as it opposite to the system sought. Good or Bad. It will never happen even if Greek Communist party came to become the rulling party. As for the loan issue it will be closed in the coming weeks.


    2. @V
      "It will never happen" ... You were equally certain also some weeks ago about Syriza not winning the election, and look what happened. With Syriza in power now the "drachma question" will stay on the table ... Or do you really think that this government will/can/want to carry through a real reform agenda?

  4. @V
    Unknown to most Greeks their country is on trial every day. Europe keeps pondering: "Will Greece keep the agreements they have signed and re-signed, pledged and re-pledged, so many times since they joined the club?
    The risk of Grexit will be there for many years to come, even if Greece should start keeping their promises, Greece is on parole.