The credit outlook for banks remains far from certain. Governments are withdrawing explicit and implicit support, raising the risk of creditor losses in the event of a default. The extent to which this will be mitigated by larger capital cushions is not yet clear.
With the exception of the U.S., the global economic outlook is generally gloomy. Loss given default (LGD) risks are elevated for banks everywhere except North America and Asia Mature.
Banks in emerging markets are the most fragile, but European banks have higher LGD risk due to bleak economic prospects and raised geopolitical risk. In addition, oil price volatility poses a significant threat to banks in the Middle East. While the effects may be localised, the implications could be global.
European bank regulators conducted an asset quality review and stress tests on European banks towards the end of last year. Although intended to restore confidence in the financial system, in the aftermath of the financial crisis, 24 banks failed the tests, of which 15 were in countries currently experiencing economic distress: 9 in Italy, 3 in Greece and 3 in Cyprus.
Doubts have been expressed about the robustness of these tests.
As the chart below demonstrates, creditors for most of the 24 banks are expected to suffer similar losses based on “normal” default conditions as compared to the adverse stress scenarios. Some (below the dotted line) were even at greater risk under their current profiles than under the adverse stress scenarios. This suggests that the tests were less than stringent – as if they were stringent, most of the observations would be in the red-zone.
LGD for Current Profile vs. LGD for Stress Scenario
The European stress tests show that LGD risk for the 24 banks is elevated relative to historical averages. But a more robust test would most likely have improved creditor confidence.
Analysis of the test criteria shows that banks in distressed countries such as Spain were subjected to a more severe stress test than banks in stronger countries such as France. There is therefore particular concern that banks in stronger countries may in reality have undetected weaknesses, reinforcing the need for robust LGD and stress test methodologies which do not solely rely on historical data.
I spoke more in-depth about this topic at a webinar we hosted recently. Watch the replay here: http://www.spcapitaliq-credit.com/loss-given-default-webinar/
For more information about how S&P Capital IQ can help you evaluate potential losses, find out about our Loss Given Default (LGD) Templates here.