European stress test to reveal banks' dividend and buyback potential

Following the lifting of restrictions on European bank dividends, the results of a Europe-wide stress test this week will provide the final verdict on how much excess capital lenders are able to return to shareholders, according to analysts.

The exercise, coordinated by the European Banking Authority, assesses the capital positions of more than 100 EU banks in a potential adverse economic scenario until 2023. Results will be unveiled after European markets close July 30.

It comes just a week after the European Central Bank removed its de facto cap on dividends and said it would allow banks to resume shareholder payouts in September.

The stress test will now reveal how much capital banks have at hand to return to stockholders through dividends and buybacks, according to Marco Troiano, deputy head of financial institutions at Scope Ratings. In a note released July 26, Troiano said the stress test results will be "a milestone for European banks" as it could set off "a normalization of distribution policies." Equity investors will gain better visibility on the amount of excess capital, if any, at each institution, and raise their demands for this to be returned, Troiano said.

Pillar 2 guidance

The stress test results will be used by regulators to determine each bank's so-called Pillar 2 guidance, an individual estimate of the capital buffer a bank should maintain on top of regulatory requirements in order to withstand stressed situations. While the guidance is not legally binding, banks typically tie their management buffers to this level, Troiano said in an interview.

"Anything above that is something management teams will be quite free to distribute," Troiano said. "So this exercise will give banks a supervisory validation that this is actually excess capital."

The ECB has so far asked banks to keep dividends and share buybacks below 15% of their combined 2019 and 2020 profits, or 20 basis points of their common equity Tier 1 ratio — whichever is lower. Once this policy expires in September, some banks may retrospectively pay out full 2019 and 2020 dividends, said Johann Scholtz, a European bank equity analyst at Morningstar. However, banks that score poorly in the stress test relative to their peers will likely have more limited scope for capital distributions in the near term, the analyst said in an interview.

"On a relative basis, [the stress test] could give a bit of an indication of which banks are at risk to still operate with some kind of constraint in terms of dividends. I don't think that it will be explicitly stated as such, but one will be able to deduce from the results," Scholtz said.

The ECB's announcement last week on lifting dividend restrictions was largely expected by investors and, as such, did not prompt dramatic share price movements for European banks, according to Scholtz. Investors have been adopting a "wait and see" approach until the test stress results are released, seeing it as the "next threshold for the banks to clear in terms of resuming normal shareholders' distributions," Scholtz added.

European bank stocks took a significant hit during the early months of the pandemic, with the STOXX Europe 600 Banks index falling more than 45% between Feb. 17, 2020, and April 3, 2020. The index has been slowly recovering since the end of 2020 amid a brightened economic outlook and the prospect of a return to normalized dividends.

Prolonged pandemic scenario

The EBA is conducting its test covering a sample of 50 European banks, while in parallel the ECB is carrying out its own stress test for another 53 banks that it directly supervises. The tests are based on banks' capital positions at the end of 2020.

The stress test's severe scenario will consider the consequences of a prolonged COVID-19 scenario in a "lower for longer" interest rate environment, in which EU GDP contracts by a cumulative 3.6% between 2021 and 2023, while unemployment rises by 4.7 percentage points.

Troiano and Scholtz both expect that European banks will largely come out strong from the test.

"Banks enter the stress test with a level of balance sheet strength that we've probably never seen before," Troiano said. "Post the financial crisis, we've had a full decade of strengthening of the sector from the perspective of capital and liquidity, with tighter regulation of the sector and a general de-risking of business models."

UniCredit analysts expect that many banks will be able to absorb the large, simulated economic shock under the adverse scenario and still exceed their minimum capital requirements, according to a stress test preview released July 28. The analysis found that banks in Benelux, France and the Nordic countries should perform well, while some banks in Ireland, Italy and Portugal will likely be in focus, with lenders such as Banco BPM SpA, Banca Monte dei Paschi di Siena SpA and Banco Comercial Português SA expected to show weaker results than peers.

In the EBA's last stress test in 2018, banks reported an average CET1 ratio of 15.3% at the end of 2017, which three years later had risen to 16.0%, according to S&P Global Market Intelligence data on a sample of banks participating in both 2018 and 2021 exercises. These levels have in part been boosted by the dividend restrictions put in place during the pandemic, and by banks' reduction of risk-weighted assets given their growth in lending backed by public guarantees, Troiano said.

The sample of banks covered by the EBA's stress test in 2021 has changed slightly since 2018, with U.K. banks such as Lloyds Banking Group PLC, Barclays PLC and NatWest Group PLC no longer being part of the exercise due to the country's departure from the EU.