Deutsche Bank and Italy's Lenders Are in Stress-Test Spotlight

(Bloomberg) -- It’s not just Italian lenders that should be worried about Europe’s toughest-ever bank test: German firms will also feel the pain.

Deutsche Bank AG will be particularly hard hit because of the more severe stress scenario applied to German lenders, according to two people familiar with the matter, who asked not to be named because the results haven’t been published. Deutsche Bank’s key measure of financial strength will fall, placing it in the lower half of the banks measured by the test, one of them said. Deutsche Bank declined to comment.

More than a decade after the financial crisis, banks are still trading at a fraction of valuations they fetched during boom times and many are struggling to move beyond repairing their businesses. They’re also grappling with other challenges, from accounting changes to slowing economies in many parts of the world and tight margins amid low interest rates.

As German banks are facing intense competitive pressure at home, Italian lenders are seeing their capital levels eroded after a standoff between the country’s populist government and the European Union sparked a slump in the state’s bonds. Shares in Italian banks have plummeted and S&P Global Ratings has cut its outlook on 11 of the country’s lenders, including Intesa Sanpaolo SpA, Banca IMI SpA and Mediobanca SpA.

The results of the test will show how just how resilient 48 lenders are in a severe economic downturn. While there’s no pass or fail grade, the outcome of the stress test matters because it helps determine whether banks need more capital or if they can instead increase shareholder dividends and staff bonuses.

The EBA’s assessment, designed last year, assumes that the yield on Italian 10-year government bonds rises by 125 basis points from end-2017. While generic prices on Bloomberg show the yield is already up by more than that this year, Italy is a long way from the economic contraction featured in the test.

Intesa Chief Executive Officer Carlo Messina said he’s not concerned about the impact of Italy’s falling bond values and there’s “absolutely” no sign of depositor flight from the country’s banks.

Investors in German banks may focus on the test’s negative feedback loop of weak bank profitability and lower growth. The EBA also factors in losses in complex trading assets, of which Deutsche Bank has many.

NordLB has the weakest balance sheet of any German bank participating in the stress test, and people familiar with the matter said they expect the company’s key capital ratio to fall to 7 percent, well short of regulatory requirements. NordLB may combine with rivals to help consolidate Europe’s most fragmented banking market.

Bigger Picture

Looking at the bigger picture, the ECB says the top risk for European banks is geopolitical uncertainty created by events such as Brexit. The stress test will take account of that with “a wide range of macroeconomic risks” possibly stemming from Britain’s withdrawal from the EU, according to the EBA.

In general, European banks “should be better prepared than in previous rounds because they have stronger capital cushions and a less risky asset base," Bernd Ackermann, an S&P credit analyst, said in a report. However, the test’s application of new accounting standards and “slightly more severe macro-financial assumptions” might offset these benefits, he said.

To contact the reporters on this story: Nicholas Comfort in Frankfurt at ncomfort1@bloomberg.net;Steven Arons in Frankfurt at sarons@bloomberg.net

To contact the editors responsible for this story: Sree Vidya Bhaktavatsalam at sbhaktavatsa@bloomberg.net, Andrew Blackman

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