Friday, 8 May 2009

Stress Tests

8th May 2009

The Malta Independent - Friday Wisdom

Bank regulators and monetary authorities around the world, bruised by the experience of the financial turmoil following the Lehman collapse last September, are intensifying their stress testing mechanisms for significantly important banks under their purview, to ensure that for the future they are well cushioned with sufficient capital to withstand further turmoil.

Lax banking supervision and insufficiently rigorous past stress testing forced governments to intervene to avert further crisis, re-capitalising some of the significantly important banks. Strong banking brands such as Citigroup, Royal Bank of Scotland, Lloyds Bank, Halifax Bank of Scotland, Fortis Bank, Commerzbank and Hypo Real Estate are still on their feet only thanks to crisis support from their governments. Other well known investment banks, like Bear Stearns and Merryl Lynch had to be absorbed by larger outfits in distressed conditions.

In a bid for transparency meant to increase confidence in the banking system, such stress tests have started being published. There are some who doubt if this will in fact not have the contra-effect if they reveal inadequate capitalisation. Their publication is awaited with trepidation.

In Malta, the Central Bank has just published its first Financial Stability Report 2008 dealing with the entire system. It has, with good reason, not published the individual results of the respective institutions.

The conclusions of the report are written in very guarded language and in some parts it is even contradictory. For example, it is difficult to see how a statement like “stress tests undertaken by the Bank (Central Bank of Malta) confirm that, on average, the banks have sufficient capital buffers to withstand extreme yet plausible shocks” can co-exist with an earlier statement that “Banks in Malta remain for the most part adequately capitalised ... however ... additional capital may be required to meet risks ... if the existing resilience of banks to extreme but plausible shocks is to be maintained”.

Apart from the conflicting nature of these conclusions the reference to “on average” and “for the most part” indicate that the Central Bank has reservations about the capital adequacy of some individual institutions. Individual institutions, if significantly important, may be crucial for the overall stability of the whole system and therefore such inferences should not be disregarded lightly.

While the Central Bank does not report separately on each institution, it is only logical to conclude that it may have reservations on the capital adequacy of one of the significantly important banks. As an objective and independent analyst I tried to explore whether Bank of Valletta, as a significantly important bank that has so far reported the highest turmoil related losses, has adequate capital to withstand “extreme but plausible shocks” that may be in store for the future.

Bank of Valletta has just published its interim financial statements for the six months to March 2009 where it reported a net profit of e6.3 million down from e25 million in the same period prior year. The results show that the Bank had to make further provisions on the “fair value” of its investments brining the total such provisions since the turmoil started to e84 million. The Bank made a statement it expects to claw back “much but not all” of these provisions over time as it holds such instruments through the period till final redemption.

The crux is that that reported losses are theoretical resulting from much criticised “mark to market” accountancy rules which force Banks to write-down the value of their investments to the last market price even if such price results from an inefficient, distressed and highly illiquid market. Possibly Bank of Valletta has reported higher losses than its peers for two reasons. One is that such investments were held in its trading book forcing it to recognise valuation losses through the profit and loss whereas peers held such investments in the available-for-sale or held-to-maturity categories which permits technically for valuation losses to be passed through the balance sheet reserves or amortised to maturity.

It is truly a case where Bank of Valletta is being punished for its prudency. Having a loan to deposit ratio of just 67 per cent the Bank has been forced to keep a significant part of its assets in what it describes as securities issued by “quality, credit rated, sovereign, supranational, corporate and financial institutions”. It is these securities that have contributed to the booked losses. The local loan book has remained sound and impairment charges on the loan exposure it is still extremely low.

Future stress is unlikely to come directly from the financial turmoil as happened these last 18 months. Future losses are more likely to result from the lagged effects of the general economic recession which reduces the loan book quality and will necessitate higher recovery provisions. This applies as much to Bank of Valletta as to its peers. Going forward it seems that Bank of Valletta, unlike other banks, will be able to cushion such increased provisions on their loan book by the recovery of provisions on investments as international financial markets stabilise and bonds approach their maturity date.

With a Tier 1 capital ratio of 10.50 per cent Bank of Valletta appears well capitalised and there is no risk that it may have to be forced to make a rights issue even if the local economic situations worsens beyond expectations.

What Bank of Valletta should have done in these circumstances, is cancel their interim dividend. Paying out an interim dividend, which even if reduced, still exceeds the profits of the first six months of the financial year, erodes capital when prudency demand capital should be protected.

In the current circumstances Bank of Valletta’s management should be less sensitive to its equity price and focus more on the long term stability of the bank which is the most important element that protects shareholder value for the longer term

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