RBS and Lloyds exposure to sovereign debt eyed by Citi analysts

The European Banking Authority’s (EBA’s) finding that just eight out 90 European banks failed its ‘stress testing’ has been heavily criticised in some quarters, with the test seen as having been too ‘soft’ on exposure to sovereign debt.

Analysts at Citi have carried out what they believe is a deeper, more demanding analysis that includes a ‘full sovereign book stress’ test. The resulting headline finding from the Citi analysis is that 31 of the 90 banks fail the revised, stiffer version of the EBA test.

The issue of sovereign debt exposure among banks is becoming an increasingly hot potato due to the fresh debt crisis engulfing euroland, with Italy, the third biggest economy in Europe, having suddenly emerged as the new victim, joining Portugal, Ireland, Greece and Spain.

While the EBA’s stress test has been criticised as having a flawed methodology and being based on inconsistent data, the exercise has also led to some praise for having at least generated greater disclosure from banks.

At the heart of the EBA’s methodology is the setting of a 5 percent threshold for core Tier 1 capital  - the ratio of a bank's core equity capital to its total risk weighted assets - for 2012.

Banks with less than 5 percent were declared to have failed.

Citi’s European banks team, led by Henrik Christiansson, says that while it likes elements of the EBA methodology, and welcomes the resulting enhanced disclosure from banks, it would have preferred a full blow sovereign test to have been included.

To this end the analysts took the EBA results as their starting point, and added to them a stress of sovereign banking book exposures using the the EBA’s own five year stress parameters.

While Citi’s sterner methodology and parameters results in 31 banks failing at 5% Tier 1 threshold, an additional augmented test at a minimum threshold of 6% leads to almost half of the banks, 43, failing.

Looking specifically at the EBA findings for UK banks, Citi says they generally screen well in the Authority’s own stress test. This is due to their generally good starting capital ratios, averaging 10% in 2010 across the majors.

Drilling down across the UK sector, Citi concludes that on the basis of the EBA test, Royal Bank of Scotland is the worst performer among UK banks, slipping into the second group of "near-fails" in the 6-7% core Tier 1 threshold range.

The broker believes the poor performance of RBS reflects shortcomings in the EBA’s stress test methodology, which penalises the bank relative to peers.

RBS suffered, for instance, from the EBA using the historical average trading income for its forecasts, including 2008 losses, says Citi.

The Authority also deemed mandatory restructuring plans for a number of banks following the 2009 crisis as mitigating factors for assessment purposes – as with Lloyds Banking Group - but not where they were non-mandatory, as with RBS.

Such factors in the EBA’s methodology mean its baseline scenario for institutions varies significantly versus Citi’s own forecasts, with Barclays the only UK bank where the Authority’s baseline net profit estimate is even close to the broker’s 2012 estimates.

The broker says the evidence so far shows that most UK banks have limited sovereign exposures to the peripheral countries, outside of Italy. Within this group, however, RBS and Barclays do appear to have much larger credit exposures to the peripherals.

The lending exposure is concentrated in Ireland for RBS; and Spain (and Italy) for Barclays (LON:BARC). For HSBC (LON:HSBA), the peripheral exposure is relatively small.

Lloyds, meanwhile, has not disclosed any lending exposure outside of the UK and US. Instead its remaining credit exposure has been listed under the ‘other’ category:  “We believe that the majority of this is attributable to Ireland,” says Citi.

Yesterday, shares in Lloyds, RBS and Barclays fell to their lowest for 17 months on concerns about their exposure to sovereign debt. Lloyds was the biggest faller, dropping 7.5 per cent.

Today, though, the sector mounted a recovery of sorts, clawing back some of the losses. By midday Royal Bank of Scotland was ahead 0.58 pence to 33.55 pence; Lloyds was ahead 1.57 pence to 42.92 pence; and Barclays was up 8.48 pence to 216.13 pence.