Europe finance: Stressed out?

FROM THE ECONOMIST INTELLIGENCE UNIT

The results of the EU’s bank stress tests, conducted by the Committee of European Banking Supervisors (CEBS) and published on July 23rd, have so far caused few ripples, positive or negative, in financial markets. Although all the main European financial institutions were deemed to have passed the tests, seven second-tier banks failed and will need to raise €3.5bn of new capital, a modest amount even for fiscally burdened European states. However, this superficially benign outcome is unlikely to convince sceptical markets that the region’s banking system is fundamentally sound. For political as well as financial reasons, many aspects of the stress tests appear far from stressful, with low pass thresholds, generous definitions of banks’ capital strength and exposure to government debt, and no provision for the possibility of sovereign default. With many banks still wholly reliant for their survival on state support, further anxiety may well lie ahead.

The route to agreeing to conduct the stress tests had put EU policymakers in something of a bind. The idea originated in Spain, as domestic regulators and policymakers looked to the tests as a way of relieving financial market pressure on their beleaguered banking system. By supposedly bringing greater transparency to the holdings of Spanish banks, especially the country’s troubled savings banks (cajas), regulators hoped to ward off speculative pressure on the sector and give its reorganisation a boost. However, once Spain had agreed to publicise its results, other EU member states known to have troubled banking sectors came under pressure to conduct similar tests. The exposure of German and French banks to peripheral euro area sovereign debt meant that German and French leaders were eventually forced, reluctantly, to agree to the stress tests, and before long the exercise was widened considerably, to some 91 banks covering 65% of the EU’s banking system. The dynamics of the stress tests’ inception meant that political resistance to truly severe examinations was high.

Damned if you do…

The CEBS faced a daunting task. Subject the banks to strongly adverse scenarios, and a deep swathe of the European banking sector would require recapitalisation. Conversely, conduct a mild version of the stress tests, with weak adverse scenarios, and accusations of whitewash would fail to allay concerns over banks’ exposure to sovereign and private debt in troubled peripheral economies. Furthermore, as with most EU initiatives on the financial crisis, national political concerns played an important role in determining policymakers’ attitude to the banking tests.

In this case, political considerations led to the pre-emptive elimination of sovereign default from the range of scenarios that the banks were tested on. The CEBS decided that the existence of the European Financial Stability Facility (EFSF), the €750bn EU-IMF bailout fund, was sufficient to rule out the possibility of sovereign default. Unspoken was the concern that the EFSF is not pre-funded and, thus, draws on funds from the financial markets at the precise time when risk aversion is likely to be running high in the wake of financial turmoil at a member state.

Given the political constraints facing the CEBS, it opted for mildly testing central and adverse scenarios (see “Testing times“), but some of its other assumptions were more questionable. The decision to only consider declines in the value of sovereign bonds held on banks’ trading books, rather than those deemed to be held to maturity, means that the largest share of sovereign holdings were not exposed to stress-testing—even though they would be just as affected by a sovereign default.

The selection of 6% of Tier-1 capital as a benchmark “pass” also allowed fewer banks to fail the tests; a considerably higher number of institutions would have required recapitalisations if the stress tests had assumed that a Tier-1 ratio of 7% was necessary. Moreover, the definition of Tier-1 capital used in the tests was deliberately broad, including various types of hybrid debt instruments (rather than a stricter and narrower definition comprising just equity and retained earnings), that leaves many questions unanswered as to the true risk-absorbing ability of banks’ core capital. Finally, the process is open to criticism of being contrived, given that the banks it identified as requiring recapitalisation were already, by and large, recognised as fundamentally weak and insolvent banks, and most were in the process of securing new capital one way or another. The unexpected failure of a bank that had previously been perceived as well capitalised would (perversely) probably have boosted the credibility of the tests.

Markets unmoved

European (and other) financial markets took the results of the stress tests in their stride, which was probably attributable to a number of factors. First, the predictability of the outcome—with seven already poorly performing banks failing—meant that uncertainty over the European banking sector had not marginally increased. Second, the lack of advance disclosure of the nature of the stress-test scenarios meant that markets were likely already to have decided ahead of the results that the tests were not going to address materially adverse scenarios, such as a string of sovereign defaults on the periphery of the euro area—which is the precise state of affairs that financial observers worry could bring down European banks.

Third, the CEBS seems to have opted for some middle ground between, on the one hand, a discomforting lack of disclosure and, on the other, a potentially catastrophic stress-test outcome. The latter would have risked precipitating a renewed confidence crisis over euro area sovereign debt and triggering the need for major simultaneous recapitalisations of a large number of banks—precisely the situation that European regulators are desperate to avoid.

A futile exercise?

It is debatable whether the stress tests have advanced the situation in terms of securing the apparent stability of the European banking sector. The CEBS’s adverse scenario to gauge the health of banks in 2010-11 is more benign than the Economist Intelligence Unit’s central forecasts for certain countries. The adverse scenario includes a “sovereign shock”, which is defined as a sharp deterioration in the market value of sovereign debt (but not a default or restructuring). The test administrators give their adverse scenario only a 5% chance of occurring, dubbing it “plausible but extreme”. In contrast, we forecast that Greece will restructure its public debt in 2012 and cut the value of its bonds by 30% (the stress tests assume a temporary 23% drop in the value of Greek debt by 2011). Compared with the test’s worst-case scenario, our central forecast is also more pessimistic about GDP growth in Greece, Hungary and Lithuania in 2010, while we expect a higher unemployment rate in Greece, Ireland, the Netherlands, Slovenia, Bulgaria, the Czech Republic and Poland.

As a result, there will continue to be concerns in financial markets over the stability and resilience of certain European banks. It is to be hoped (maybe somewhat optimistically) that those institutions that only narrowly passed the tests may decide that they would benefit from raising further equity capital. Indeed, there has been some evidence of this occurring. Encouragingly, the tests have strengthened the rationale for Spain’s banking sector restructuring fund (FROB), the lifetime of which has now been extended.

However, the stress tests still leave the European banking sector at risk of further market panic over exposure to weak euro area sovereigns. The whole process has demonstrated once again that the factors contributing to the continued weak state of European banks are not just financial, but also political. European leaders have proved themselves unwilling to countenance the true worst-case scenarios that financial market participants have long identified as the “stress” that could seriously threaten the region’s entire banking sector. For stress-test scenarios to be taken seriously, they need to include an assessment of the implications of possible default of certain euro area sovereigns and the consequent devaluation of their borrowings. But admitting this in public is a test that European policymakers continue to fail.