Creditflux Newsletter

Societe Generale credit financials analysts have recommended buying subordinated credit default swap protection on Deutsche Bank and selling subordinated CDS protection on HSBC as a means to hedge against - and possibly capitalise on - today’s EU bank stress test results. Deutsche begins this test from a relatively low capitalisation level, says SocGen, and, as such, may only just pass. HSBC approaches them from the opposite condition. At the same time, senior and subordinated CDS trade at their long-term average relative to each other.

Deutsche Bank may fall into the ‘near-fail’ zone under the adverse scenario, due to the full application of ‘capital requirements directive III’ in the stress test results. Banco Popolare and Commerzbank may also be ‘near fails’.

Analysts do not believe that the possibility of Deutsche Bank as a ‘near fail’ is currently priced in the CDS markets. Deutsche reported a Basel II core tier-one ratio of 9.6%, as of 31 March. Adding €93 billion of market risk-weighted assets, as per the Basel 2.5 requirement, results in a reduction of approximately 210bp to its core tier-one ratio (Basel 2.5 is incorporated in the CRD III requirements). Further adjusting for a possible 100-150bp impact of the adverse stress test and Deutsche may move into the near-fail territory, says SocGen.

Given the depth of the anticipated disclosure and the need for the European Banking Authority (EBA) to be seen to have been tough on the banks, SocGen anticipates a broad, short-term, positive impact in the credit market from the upcoming EU stress test publication. However, over the longer-term, the stress test is unlikely to assuage broader market concerns with respect to eurozone banks.

Furthermore, version two of the published EU stress tests does not address the real issue surrounding certain EU banking systems, say analysts. The issue is one of the ability to resolve a banking crisis, as the ability to predict them is poor. For all the talk of incorporating ‘lessons learned’ in this year’s’ stress tests, SocGen believes the real lessons from the Irish banking system meltdown are missing from these tests and they relate to funding and liquidity risks. Addressing the capacity of sovereign, inter-connected, states to resolve potential funding or liquidity issues of their respective banks within the constraint of a currency union, is the key to providing long term market calm.