The results of the Oliver Wyman Spanish banking sector stress test are out, and despite the figures promulgated by the mass media, one doesn't have to make any outlandishly pessimistic assumptions to come to the conclusion that Spain's banks need far more than the advertised 62 billion euros.
The report presents two alternative scenarios: the 'base' scenario under which Spain's banks will need just 16-25 billion euros, and the 'adverse scenario' under which the sector will need 51-62 billion euros. The adverse scenario figure is the number the media has focused on. Supposedly it shows that, even in the worst case scenario, Spain's banks need just a little more than half of the 100 billion euro bailout they are set to receive.
Importantly, both scenarios described in the report include an 'expected loss total' (around 260 billion euros in the adverse case and around 180 billion in the base case) and a category called 'loss absorption capacity effectively used' which includes several sub-categories that show how the banks will purportedly soak-up the expected losses. It is to two of these sub-categories that I draw the readers' attention.
Under the 'adverse' scenario, there is a sub-category called 'excess capital buffer' under which 33-39 billion euros is listed. Now it should be noted right off the bat that the idea of the Spanish banking system having 35 billion in 'excess capital buffers' seems ridiculous--these banks after all, are largely insolvent, that's why the audit is being conducted in the first place.
Putting that aside, note that the 'steering committee' (composed of the IMF, The Bank of Spain, and the ECB among others) dictates that 'post-shock capital needs' are to be determined taking a "minimum core Tier 1 ratio of 9% and 6% under the base and adverse scenarios respectively." This is critical. Recall that the European Banking Authority (EBA) has set a target date of June 30 for European financial institutions to achieve a temporary 9% Tier 1 capital ratio to "restore stability and confidence to the market." It seems then, that the steering committee is throwing 'stability and confidence' out the window when it recommends that the auditors assume only a 6% core Tier 1 ratio when calculating Spanish banks' capital needs under the so-called 'adverse case.' This leeway is what accounts for the 35 billion in 'excess capital buffers'. If you go by the EBA's stability-promoting and confidence-inspiring 9% core Tier 1 capital ratio, that excess capital buffer all but disappears, adding back 35 billion to the 65 billion shortfall. That brings the total amount needed to 100 billion, the amount Spain is expected to receive via the yet to be created ESM.
So, assuming 9% Tier 1 capital, there is no breathing room--all of the 100 billion is gone. Given this, consider that the audit also assumes that Spain's banks will be able to generate 60 billion in "pre-provisions and pre-tax profits for Spanish businesses and post-provisioning, post-tax for 'non-domestic business'” from now until 2014. If this seems a bit optimistic given the circumstances, that's because it is. Spanish banking groups had only 39.548 billion in pre-tax, pre-provision profts in 2011, meaning the stress test effectively assumes the banks' profit generating capacity will not deteriorate further from now until 2014. Whether or not this is a safe assumption is certainly a debatable subject. Of course, the market environment is likely to be particularly challenging over the next several years, leading one to wonder if it wouldn't be safer to just assume for the purposes of the stress test that Spain's banks are going to continue doing what they are doing now: struggling to stay afloat.
Given this, it is probably safe to just add the 60 billion euros in expected 'new profits' back to the total needed, which the reader will recall stands at 100 billion euros after adding back the 35 billion euros derived from using a lower Tier 1 capital ratio for the adverse scenario calculations. The total needed then, under a conservative interpretation of the test results, is more like 165 billion euros, 65% more than the allotted bailout.
In sum, investors should be careful about interpreting the results of the Oliver Wyman stress test to mean that Spain's banks need 40% less money than originally planned for. This line of thinking could easily lead one to believe that things aren't as bad as they seem in Spain when the reality is that things are probably even worse than they appear. Conclusion: more bailouts, more volatility, more uncertainty. Short European stocks (FEZ), short S&P 500 (SPY), long volatility, short Euro.
Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in FEZ over the next 72 hours.