This week, the European Banking Authority (EBA) and the European Central Bank (ECB) have launched the stress tests they conduct every two years on European banks. The objective of these results is to assess the resilience of banks in the face of severe deterioration in the economic and financial scenario, understand the vulnerabilities of the sector, and measure their capacity to continue financing the real economy in adverse situations.
There is widespread consensus in economic literature recognizing the benefits of productive and geographic diversification, and the banking sector is no exception.
Traditionally, the results of Spanish banks have been strong, largely thanks to a business model based on subsidiaries that allows them to benefit from the geographic diversification of their investments.
There are two factors that enhance the advantages that diversification would have for Spanish banks compared to any other sector.
First, Spanish banks have expanded internationally through subsidiaries that in most cases are autonomous from a capital and liquidity standpoint—that is, they have access to local wholesale capital markets on their own without needing support from parent companies, and can develop their activities independently from their parent. This autonomy allows for rigorous knowledge of local markets and enables the adaptation of local products and services to the needs of each region. Although subsidiaries are subject to rigorous control systems exercised by parent companies, this autonomy provides subsidiaries with the necessary flexibility to swiftly adapt their product offerings to local markets.
Second, it could be stated that, in general terms, the development of their international activities takes place in economies whose performance is weakly correlated with the Spanish economy, as has been historically demonstrated when, thanks to this model, the solvency of banking groups has remained intact despite local macroeconomic crises that have occurred in some of the jurisdictions where our banks operate. This means that when one country faces difficulties, the bank can continue operating in other geographies.
As a consequence of the above, it is observed that Spanish banks are capable of generating recurring and efficient profitability, with increasing weight of international results over domestic ones in the case of large institutions, enabling organic capital generation that would ultimately serve, on one hand, to absorb potential losses in an adverse scenario and, on the other hand, enable them to continue with the financial intermediation function essential to provide the financing required by the economy.
Furthermore, from a financial stability perspective, this model ensures the non-transmission of crises within a group, so that if a subsidiary had to face a local crisis, the possible negative consequences would not be transmitted to the rest of the group’s subsidiaries. In short, it prevents contagion between entities within the same group.
However, despite the fact that the subsidiary banking model has benefits not only for banks and their clients but also for society as a whole, as it minimizes systemic risks, the EBA’s methodology has some limitations that penalize this model.
On one hand, the methodology used does not take into account the benefits of geographic diversification—negative correlation between jurisdictions. The adverse scenario is the same for all jurisdictions without considering that the negative effects of a crisis in one region may be offset by positive effects from other events in other regions.
Additionally, the methodology overestimates the potential negative impact of exchange rates on capital. The negative assumption about the evolution of the Euro affects some very relevant income items, but does not affect equally important expense items.
During 2020, the EBA published a document with possible changes to the stress test methodology with the aim of improving transparency, enhancing relevance, and making them more efficient. We hope that the future methodology will take these factors into account.
Whatever the supervisors’ decision regarding the future stress test methodology, we expect that Spanish banks will continue to perform well—that is, they would have a lower capital impact from the adverse scenario—both in the exercise that began this week, whose results will be published in July, and in future exercises. Beyond the demanding regulation and strict supervision lies their experience in business and risk management in a global world.
Pedro Cadarso, Advisor to the Spanish Banking Association (AEB)
