Kenniscentrum

Confidence in the European banking system was buoyed by largely positive stress test results published on 23 July, although the initial market reaction was somewhat subdued. Most broad indices made marginal gains on the first day of trading, and prices for European Financials and peripheral government bonds also rose after the results were posted. The muted reaction suggests that the results of the stress tests were anticipated by investors and do not appear to be a catalyst for a major revision in expectations. At the margin, SEI believes the exercise was a positive one, providing for improved disclosure of banks’ exposure to troubled debt.

Background

The sovereign debt crisis (notably in Greece) has cast a pall on investor sentiment for much of 2010. In order to assuage fears about a financial system melt-down, the European Union announced its Committee of European Banking Supervisors would conduct “stress tests” on its banks to forecast the effects of stunted or declining economic growth, as well as further price declines by European government bonds, which would lead to losses for the banks that are invested in these bonds. The banks were tested against the three following scenarios for the wider economic environment and sovereign debt stresses:

• A “baseline” scenario, in which growth (as measured by Gross Domestic Product, GDP) was expected to continue at a rate of 1.0% in 2010 and 1.7% in 2011.
• An “adverse” scenario, which forecasted no growth in 2010 and a drop of 0.4% in 2011.
• A “sovereign shock” scenario, which combined the “adverse” scenario with a financial crisis for European governments that led to write-downs in the value of their debt (known as a “haircut”). These measures were, for example, a 23% “haircut” for Greece, 14% for Portugal, 12% for Spain and 10% for the U.K.

Banks were deemed to have passed the stress test if they met the required tier one capital ratio of 6% or higher. A tier one capital ratio compares a bank’s equity capital to its total risk-weighted assets. Risk-weighted assets are calculated by giving less weight to a less risky asset and more weight to assets considered relatively riskier. The tier one capital ratio is seen as a way to discern a bank’s ability to sustain future losses.

Of the 91 European banks (which represent almost two-thirds of the EU’s Financials sector) under scrutiny, only seven failed the test, although another 12 banks only passed by a marginal amount. Of those that did not meet the requirements, one was German, one was Greek and five were local Spanish savings banks (or cajas). While the market had widely anticipated that the cajas would fare poorly, Spain’s larger banks (particularly Santander) performed well. All of the U.K.’s leading banks passed, as did France’s leading four.

SEI’s View

In SEI’s view, the European bank stress tests have reduced some uncertainties and increased transparency into the financial health of these institutions. Some critics of the stress tests have argued, however, that they did not go far enough for the following reasons:

• The scenarios on which the stress tests were based were not severe enough in light of recent risks of default experienced by peripheral European sovereign debt; “haircuts” were applied only to bank’s trading accounts, instead of to both their trading accounts and bank accounts.
• Tier one capital ratios may not fully indicate a bank’s ability to withstand substantial losses.
• Tier one capital includes some securities that are viewed as an inferior capital buffer compared to equity and retained earnings, which are kept by the company and aren’t paid out to investors.
• The hurdle rate for the tier one capital ratio was 6%, but 17 additional banks would have failed the stress tests if 7% were used as the standard.

The Basel Committee on Banking Supervision, a forum for international cooperation on the oversight of the banking industry, is currently in the process of developing new proposals that will tighten both capital and liquidity requirements for global banks. Amongst other initiatives, the Committee is revising its definition of tier one capital ratios. Further decisions are expected during this autumn.

Markets may react more vigorously in the coming weeks, as many European banks release corporate earnings results. These earnings announcements should provide additional clarification to help determine which banks are strong enough to hold up against possible economic and financial crises in the future. SEI believes that risks surrounding peripheral European sovereign debt and the broader global economy are likely to remain important considerations for investors, but these risks will vary from country to country. While peripheral Europe continues to struggle to achieve a balance between government cost-cutting and a return to recessionary conditions, core European economies are experiencing a rebound, as reflected by the positive Ifo survey of German business conditions released last week. Therefore, we are currently emphasising the importance of security selection in our Funds.

SEI’s Funds

While SEI’s equity and fixed income Funds have exposure in European Financials, we do not hold any of the banks that failed the stress tests as at 30 June.

In SEI’s U.K., European and global fixed-income portfolios, our Funds were generally overweight in Financials as at 30 June but underweight in peripheral European Financials and government debt.

In SEI’s UK and European equity portfolios, our Funds were underweight in the Financials sector, particularly in banks.

In SEI’s international equity portfolios, our Funds were also underweight in Financials.

Important Information:

Past performance is not a guarantee of future performance.
Investment in the range of SEI’s Funds is intended as a long-term investment. The value of an investment and any income from it can go down as well as up. Investors may not get back the original amount invested. Additionally, this investment may not be suitable for everyone. If you should have any doubt whether it is suitable for you, you should obtain expert advice.

No offer of any security is made hereby. Recipients of this information who intend to apply for shares in any SEI Fund are reminded that any such application may be made solely on the basis of the information contained in the Prospectus. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts.

If the investment is withdrawn in the early years it may not return the full amount invested. In addition to the normal risks associated with equity investing, international investments may involve risk of capital loss from unfavourable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments and smaller companies typically exhibit higher volatility. Products of companies in which technology funds invest may be subject to severe competition and rapid obsolescence. SEI Funds may use derivative instruments such as futures, forwards, options, swaps, contracts for differences, credit derivatives, caps, floors and currency forward contracts. These instruments may be used for hedging purposes and/or investment purposes.

While considerable care has been taken to ensure the information contained within this document is accurate and up-to-date, no warranty is given as to the accuracy or completeness of any information and no liability is accepted for any errors or omissions in such information or any action taken on the basis of this information.

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