Saturday, July 24, 2010

Europe’s Bank Stress Tests: Nothing but a Dog and Pony Show
Joe El Rady

Think back to your school days. If a teacher gives a test, and everyone in the class passes, doesn’t that make you question the difficulty of the test?

The European Union’s Bank Stress Test found that 91 banks in 20 European countries could withstand 566 billion Euros ($730 billion) in total losses. Only seven banks flunked the tests… and not by much. Those that failed only did so with a combined 3.5 billion Euro capital shortfall. Most independent analysts, by contrast, forecasted that 20 banks would fail by a combined capital shortfall of at least 30 billion Euros.

The tests assessed the impact of what regulators called a “sovereign shock.” They defined this shock as losses on bank trading portfolios due to falling prices on government bond portfolios.

You know what I hate? Answers to questions that I didn’t ask. The question isn’t whether or not the banks can withstand losses from falling bond prices, but whether or not the banks can withstand a sovereign default by a European country (the foreboding of which from Greece started this whole mess in the beginning). The regulators clearly and boldly stated, earlier this month, that they opposed testing the consequences of a sovereign debt default as it would imply that the EU's bailout fund was not guaranteed to work. Finally, a clear statement. Clear but dangerous. Basically, European regulators think Greece, Spain, Portugal etc are too big to fail. So why test the scenario? It won’t happen. Germany and France will rescue their neighbors. Moral hazard lives!

Furthermore, the question isn’t merely whether the banks can withstand losses on their trading portfolios, but also whether or not the banks can withstand losses on their total portfolios, including those bonds classified as “held to maturity” rather than “held for trading.”

Aside from merely asking the wrong questions, the European stress test set very low hurdles. The price falls assumed by the stress model seem quite low. Under the nightmare scenario, the stress test model assumed that Greek five year bonds would yield 13.64 percent, equivalent to a 23 percent price drop. That seems fairly large, but remember that Greek five year bonds yielded 17 percent during the sovereign crisis. Moreover, the stress test set a very low hurdle of capital adequacy by employing a 6 percent Tier 1 capital ratio requirement. Most European banks currently average 10 percent Tier 1 capital, and recently, the Swiss government employed an 8 percent Tier 1 capital ratio for a similar test.

In order to legitimize this farce, European officials stated Friday that their tests were more rigorous than the U.S. tests. You know what I hate more than answers to questions that I didn’t ask? Answers to questions that are irrelevant.

To their credit, at least the tests did provide investors with greater transparency by forcing the banks to disclose their total sovereign debt portfolios.