How good is the capitalization of the Romanian banking system?

The representatives of the banking sector claim that the system has a particularly good capitalization and a good liquidity, and that at the end of 2020 the banking system was stable, with a solvency of more than 25% and much improved liquidity. According to NBR data, the solvency indicator of the banking system was 25.1%, in the last quarter of 2020, and has recorded a slight drop in Q1 2021, to 24.6% (see chart 1).

Even so, the level is three times higher than 8%, the level below which the ratio may not descend, according to the capital adequacy regulatory requirements. The minimum, 11.9%, was seen in Q3 2008.

At first glance, a value of the solvency ratio that is three times higher than the minimum regulatory requirement represents a very good capitalization, but there are a number of "dangerous" elements, first impression aside.

One of the most important is the fact that the capital adequacy rate is calculated as a ratio between capital and the total amount of the risk weighted assets, and the internal and international regulations assign zero weight exposures to sovereign debt, namely government bonds.

Let's suppose a bank has a balance sheet of 100 monetary units, made up of loans (50 units) and government bonds (50 units) on the asset side, and on the liabilities side there is the capital (10 units) and customer deposits (90 units).

If the weighted risk for loans is 50%, then the total value of the risk weighted assets is 0.5x50+0x50, meaning 25 units. Under these circumstances, the capital adequacy rate is 10/25, meaning 40%.

If the loan balance sheet structure changes to 40 units worth of loans and 60 units worth of bonds, then the risk weighted assets will be 0.5x40+0x60, meaning 20 units, and the capital adequacy rate will increase to 50%.

Such a change in the balance sheet structure has been observed for the Romanian banking system, where the weight of the negotiable securities (bonds) in the total balance sheet has exceeded 22% since the beginning of the current year, after a strong increase in the last decade (see chart 2).

The weight of loans went on a downward trend after January 2008, when the peak was reached, of 87.6% of the total assets of the banking system. Currently, the weight of loans has reached about 56%.

It has come to this situation after an 18-fold increase of the amount of bonds in the total balance sheet of the banking system since 2007, while total assets increased 3.5 times, and loans increased 2.3 times (see chart 3).

Over the same period, deposits have increased 4.3 times, to 460.7 billion lei in April 2021, and the capital and reserves have increased over 4.5 times, to 447.9 billion lei.

In the monthly report concerning public debt in March 2021, the Finance Ministry states that the banking system held government bonds issued on the domestic market with a face value of 121.67 billion lei.

The NBR data concerning the balance sheet item "Negotiable securities" shows a face value of 138.45 billion lei in March 2021 and of 142.57 billion lei in April 2021. The difference between the data from the NBR and from the Ministry of Finance can include bonds issued by the local companies on the domestic or international market, as well as bonds issued by the Romanian government in Euros on the international markets.

At any rate the exposure to the bonds issued domestically is large enough by itself to create problems to the banking system if a significant interest rate hike occurred, which will lead to the massive drop in the market value of these loans.

The international financial press analyzed, both during the sovereign debt crisis in the Eurozone, as well as more recently, the phenomenon known as "doom loop".

The term describes the implications of the connection between banks and the governments they have lent to, especially through bond issues.

Thus, "sovereign states have been exposed to the banking risk, and banks are exposed to the sovereign risk", as stated in an analysis of the European Systemic Risk Board (ESRB) in the spring of 2018.

Could it be argued that such a doom loop has been "primed" for Romania? Of course, especially when we witness the explosive increase in the balance sheet item "negotiable securities" since the autumn of 2019.

In October 2019 the 100 billion lei threshold has been passed, and in the next 19 months the increase was 41.4%, amid a 17.9% increase of capital and 21.8% of the total assets.

The NBR has started publishing the results of some quarterly polls concerning the systemic risks in December 2017. The first report showed that the risks of intensifying the connection between the banking system and the public sector was ranked seventh in the chart of systemic risk, being considered moderate and relatively easy to manage.

In the last report, of September 2020, the risk of the intensification of the tie between the banking sector and the public sector is considered high, but relatively easy to manage.

Since then, the NBR has not published that kind of reports, even though one was supposed to come out in March 2021, according to the switch to the quarterly publication frequency.

Beyond the accelerated increase in the amount of government bonds in the total balance sheet of the Romanian banking system, an important factor in "improving" the solvency are the government secured loans, such as those of the "Prima casă" (First Home) program.

According to the capital adequacy regulations concerning, the weighted risk for the residential mortgage loans can be at least 35%, but in the case of mortgages the weight could be much lower, meaning it will contribute to the reduction of the amount of the risk weighted assets, in other words to the increase of the solvency for the same capital level.

It should not be forgotten that the debts "accumulated" by the population as part of the "First home" program are also contingent government debts. An accelerated default increase, amid an increase in interest rates, could lead to the quick depletion of the guarantee fund, and the government would have to borrow huge amounts.

Under these circumstances, the warnings issued by the NBR concerning the systemic risks have long since stopped being enough, but rather they need to be accompanied by drastic measures.

Is the capitalization degree of the banking system enough in the case of a "perfect storm" fueled by an interest rate hike, shrinking purchasing power of the population and the accelerated defaults of the "Prima casă" program?

Hard to believe. Maybe a stress test that is well worthy of that name could have provided an answer in that regard, by introducing a realistic scenario for the "normalization" of the interest rates.

But what if nobody wants to find such an answer?