All but 13 of the 130 surveyed banks passed the European Central Bank's stress testing. Does that mean we should all be investing in European banks?
Unfortunately, useful as they can be, stress tests rarely provide the whole story. Disputes about methods and politics aside, there's simply no easy numerical answer to the the question of whether a bank is resilient or not.
However, there are other ways of looking at resilience. Here are three tools that will help you differentiate between a bank that survives and a bank that thrives.
Look at overall leverage
The big differentiator in the ECB stress tests was capital adequacy, but this just isn't enough if you want to get a clear picture of risk. Why? It's horribly easy to manipulate and makes it impossible to get an apples-to-apples comparison between firms.
Capital adequacy ratios rely on risk-weighting, which assigns a "weight" between 0 and 1 to a given type of asset. Really safe stuff, like cash, would get a 0, while higher risk stuff, like equity, might get a weight of 1, with everything else falling somewhere on the spectrum.
Of course, that probably sounds rather vague, and the trouble is that it kind of is. Risk-weighting is subjective, meaning that you can do it a lot of different ways. That in turn provides an opportunity for banks to try to game the system, and that of course defeats the whole purpose of the exercise in the first place.
Rely on a simple computation instead: the leverage ratio.
This ratio takes liquid assets and divides them by total assets -- including those "off balance sheet" assets we're always hearing about.
It won't give you a distinction between the bank that's only lending to blue chip firms and the one that securitizes loans all day, but it will give you a nice, foolproof, and conservative way of assessing and comparing capital levels.
The higher the number, the more padding on the balance sheet -- and that's what you want to see.
Look at the bank's customers
Ratios are great, but there is really no replacement for risk management in banking, and that all starts with customers.
A recent study of distressed Italian banks found that banks with riskier portfolios were less able to bounce back from a major profit drop, partly because they were also more likely to try to gamble their way out of the problem by increasing loans to risky borrowers.
On the other hand, banks that recovered got tough on risk management by reducing credit to customers who started to struggle with their debts -- even if those debts were held with another bank.
In other words, the banks that survive cut off their risky customers.
It might seem obvious, but it illustrates the point that credit extension numbers don't tell you much on their own. It doesn't really matter how much or how little a bank is lending if its book is comprised of risky loans. You need to look deeper.
So, ask yourself: Who are the customers? How risky are they and how overleveraged are they? From here, you can get a clearer risk picture for a given bank.
Learn to appreciate the appearance of non-competitiveness
Related to both of the previous points is this: sometimes, a bank that doesn't look very competitive is a better bet than one which is outperforming.
An ECB study found that, prior to the financial crisis, European banks responded to rising competitive pressure in one of two ways. Some remained boring, and looked kind of uncompetitive and behind the times. Others started relying more and more on securitization, which increased their risk profiles -- and eventually made them more likely to need help once the crisis set in.
Again, it might sound obvious, but what's weird is this: for those securitization-happy banks, even having higher capital levels in place didn't really help them when things went south.
In fact, when competitiveness in the industry increases, the researchers found that more capital isn't really that helpful in ensuring financial stability.
What does this mean for you?
Assessing a bank's health and riskiness is not just about ratios and capital levels. Banks that try to outperform in the short run are taking a risk, no matter how good their balance sheets look.
That means you need to have an understanding of what a given bank actually does in order to have any kind of grasp on its risk level. If a bank goes all-out in derivatives and securitized loans, your capital ratios are going to be less important, and you need to ask yourself some serious questions about long-term business strategy.
It also means that, when it comes to banks, we should be asking the tough, non-numerical questions that we apply to any business: who are the customers? What does this company actually provide? Is this a short-term bonanza or a long-term play?
It's not as simple as a capital ratio, but it will take you a whole lot further.
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