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      Tight rules and strong oversight should buffer European banks against contagion
      TUESDAY, 14/03/2023 - Scope Ratings GmbH
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      Tight rules and strong oversight should buffer European banks against contagion

      The US bank failures of recent days and the risk of more fallout do not alter the positive base case we laid out for European banks in early 2023, although the latitude for unforeseen outcomes in a fast-moving, volatile situation demands caution.

      More US bank failures are possible in the near term and the failures will reverberate in financial markets for some time. Depending on how and how swiftly this situation is managed, market turbulence could signal greater recessionary forces and a softening of the monetary tightening stance from major central banks.

      We do not believe events in the US pose of themselves systemic risk effects to Europe hence we discount the fundamental basis for contagion. But irrational behaviour, herd mentality and the actions of aggressive short sellers mean damaging impacts cannot be excluded for targeted institutions.

      The events unfolding in real time are a test to the post-GFC regulatory set-up. In the US, authorities deserve praise for the swift resolution of the crisis; less so for failing to prevent it. SVB was a large bank, with over USD 200bn in assets, hardly an afterthought for regulators. We are not impressed, considering the post GFC regulatory architecture.

      A possible driver of contagion to Europe would be a fundamental change in how investors perceive banks i.e. no longer as the low-risk businesses they were previously believed to be, despite all the regulatory constraints they have been subjected to since the global financial crisis. We see this as unlikely.

      Beyond the solid capital and liquidity metrics displayed by EU banks, our positive skew is based on the EU’s robust regulatory and supervisory framework. This is stricter than its US counterpart and captures a far greater number of banks by size compared to the more piecemeal situation in the US where bank regulation is shared between Federal and State agencies and where oversight of smaller banks is far less scrutinous.

      The most recent US bank failures certainly raise questions about the effectiveness of US banking rules and their tailored implementation of Basel standards, specifically with respect to liquidity and interest-rate risk. With the signing into law of the Trump-era Economic Growth, Regulatory Relief, and Consumer Protection Act, the threshold for US systemically important financial institutions rose fivefold to USD 250bn. Banks below this size are spared critical oversight such as formal resolution plans or monthly liquidity tests and have no formal requirement to maintain minimum liquidity or net stable funding ratios.

      The thresholds for high supervisory scrutiny in the EU are much lower. Banks with assets above EUR 30bn are automatically included on the ECB’s list of Significant Institutions. Smaller banks can be added if they are economically significant to any Member State, have large cross-border activities or have been bailed out with EU funds. Even less significant institutions not under the umbrella of ECB supervision are subject to prudential supervision of liquidity.

      SVB also experienced very fast growth in assets in recent years. Fast asset growth is a red flag, which can signal aggressive loan origination (or deposit gathering, as was the case) or lack of appropriate controls. We believe this kind of growth at a major European bank would have attracted attention from the SSM, and likely led to earlier, and less traumatic, supervisory action.

      One thing the failed US banks had in common was very low loan/deposit ratios – a useful reminder of the dangers of assuming correlations between banks’ fundamental metrics and credit risk. At Scope, we deliberately eschew quantitative modelling approaches to bank ratings in favour of more analytical approaches.

      Access all Scope rating & research reports on ScopeOne, Scope’s digital marketplace, which includes API solutions such as for Credit Sphere

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