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More on why the EU stress tests were questionable

Financier Worldwide recently ran a review of the European stress tests, quoting yours truly a bit.  Therefore, I thought it worth republishing here, and can recommend the magazine if you're not already a subscriber:

Tested But Not Tried, Europe’s Banks Deemed To Be Safe

Muazzin Mehrban, September 2010

Like their counterparts across the Atlantic, European regulators had been keen to know whether their banks were capable of surviving extreme scenarios, such as a double-dip recession, and could avoid going bust. After weeks of anticipation, the results of 23 July revealed that seven of the 91 institutions stress-tested had failed, according to the Committee of European Banking Supervisors (CEBS). But the examinations themselves are still the subject of debate. Some have labelled them ‘murky’ and suggest that leaks and rumours played a part. Although the stress test was coordinated by the CEBS, in reality it became a rather convoluted compromise created by the 27 EU member states. Some commentators even argue that the whole process was a pointless exercise, given that the financial crisis had already passed.

Other reports suggested the tests were fundamentally flawed. Firstly, they did not include some of the continent’s most important institutions, whose financial health remains unclear.

A prime example is Germany’s KfW, which although not legally a bank,
does carry out bank like functions, including the accumulation of toxic
assets. Furthermore, those that did participate were tested at a pass
rate, a tier-one ratio of 6 percent, which was not easily defined.
Experts inferred that working out such a statistic, as a percentage of a
bank’s total assets, would not tell examiners what they needed to know –
whether a bank could withstand an exogenous shock.

In fact, the definition of tier one capital used for the test is the
reason why Germany’s Landesbanken, its group of state-owned banks, all
managed to pass. According to Chris Skinner, chief executive of Balatro,
using a narrower definition – equity and retained earnings only – could
have returned vastly different results. At the 6 percent ratio, just
seven banks, predominantly in Spain, failed. However at 8 percent, based
upon the declared results, analysts assert that 39 of the 91 banks
would have failed the test, including many of Germany’s state owned
banks. Many of these banks have been earmarked as potential failures in
the event of a severe downturn or sovereign debt crisis. But perhaps the
greatest criticism of the tests is that they made no provision for the
possibility of sovereign default. Usually banks hold most of their bonds
on their banking books with a small minority on their trading books.
Yet stress tests assumed further loss only on the value of those bonds
in the trading books, even though Greece showed that the eventuality of
default would affect both books.

Burst of confidence

Perhaps due to the ease of the tests, banks around Europe experienced
some relief. In the UK, shares of Barclays, Lloyds Banking Group and the
Royal Bank of Scotland all experienced small rallies on the market. On
the continent, Europe’s largest financial stocks were up on strong
earnings news and a lighter regulatory outlook designed to encourage
more risk-taking. France in particular saw an uptick when the results
were released. Credit Agricole, Societe Generale and Dexia all saw their
shares climb. In Berlin, Deutsche Bank reported its
earnings-with-profits had come in ahead of expectations, and was echoed
by domestic rival Commerzbank. Among the Continent’s other leading
risers were Swiss bank UBS, Amsterdam based financial services group
ING, and Italy’s UniCredit.

However, some analysts were quick to play down any long lasting benefits
from the stress tests. They say the market will focus on the earnings
season and economic data, and the tests will be forgotten. They also
point out that the tests fell short of producing meaningful results, as
they dealt with a scenario that historically occurs once every 20 years.
That said, the immediate impact of the results was declared a success
for restoring market confidence. “Some of the banks, particularly the UK
banks for example, far exceeded the expectations of capital
requirements. Even though these banks would write off almost £120
billion in the event of a crisis, it proves that they now have more than
enough capital to survive,” says Mr Skinner.

At the very least, the stress tests were likely to encourage a positive
reaction as they demonstrate that regulators have acknowledged the
possibility of bank frailty and are taking steps to address it. The key
appears to have been the fact that results were not overly dramatic.
Banks that posted better than expected second quarter results, such as
UBS and Deutsche Bank, were not overshadowed by the results of the
stress-test. This allowed the market to gain confidence from the banks
themselves, rather than merely taking comfort from the fact that they
passed.

The country which experienced the largest number of failures was Spain.
Its mid-sized Caja banks experienced the severest economic downturn of
all the EU member states. “Spain’s property implosion, which many of the
banks had been geared to support, dealt a killer blow, along with
unemployment rates that far exceed other countries, with one in five
people out of work and, in some communities, every other person
requiring state support,” explains Mr Skinner. “These conditions are far
harsher than could have been anticipated and for just seven banks to
fail from the 22 assessed is a testament to Spain’s ability to have
prepared for these conditions through its pro-cyclicality measures
earlier in the decade. However, the issue Spain really faces is how to
consolidate its disparate and inefficient banking system as demonstrated
by these Caja failures, and create a robust economy for the future.”
Nonetheless, shares in Spanish institutions performed well after results
of the stress test were made public.

Germany’s lack of disclosure

Although Germany’s banks posted satisfactory figures, their
stress-test results were criticised as the banks chose not to fully
disclose details. Europe’s regulators accused Germany and its banks of
reneging on the agreed deal to publish full details of sovereign debt
holdings. Speaking to the Financial Times, Arnoud Vossen,
secretary-general of the CEBS, the pan-European banks regulator, said
“We agreed with all supervisory authorities and with the banks in the
exercise that there would be a bank-by-bank disclosure of sovereign
risks.” Yet six of the fourteen German institutions tested – Deutsche
Bank, Postbank, Hypo Real Estate, mutual groups DZ and WGZ, and
Landesbank Berlin – did not publish as expected, a detailed breakdown of
their results. Every other European bank, with the exception of
Greece’s ATEbank, which failed the test in any case, complied with the
disclosure requirements.

One suggestion was that German institutions had something to hide.

But officials from Germany’s regulatory board defended their banks, arguing
that local laws prevented banks from being forced to publish such
details. Mr Vossen at the CEBS did not comment directly on why Germany
had backed out of the agreement, although he did say that he would be
speaking with German authorities. The European Commission was keen to
back up the secretary general and said it would encourage the few banks
which had not disclosed the information to do so. Mr Vossen was also
quick to dismiss criticism of the tests themselves, insisting that they
would calm the market. In response, German banks reasoned that they had
not been under pressure by Germany to publish the information, and said
that if they had been asked by either authority – Bafin or the
Bundesbank – they would have obliged.   

Germany also has specific issues related to its banks’ leverage ratios,
particularly among its Landesbanken. Bafin admitted that state banks
could have as much as $1 trillion of toxic debt on their balance sheets.
Recent revelations over Deutsche Bank’s exposure to high levels of debt
raised eyebrows; its second quarter financial results revealed €54bn
worth of government debt for European countries – €4.4bn with Greece,
Ireland, Portugal and Spain, and two-thirds on its trading book. “Most
of this was undeclared in the stress tests, and the Landesbanken which
are of major concern, could therefore pass the stress tests when
technically they should have failed.  This is what invoked the major
criticism,” points out Mr Skinner.

Working in Germany’s favour is its medium-sized banks. They can borrow
at low rates as investors believe the state can guarantee rolling over
their debts. Such luxuries do not exist among nations with weak public
finances, such as Spain, or with supersized banking systems, such as
Britain. There, banks with major funding deficits are more reliant on a
market recovery, and hope they can ride out their debts until this
happens. But the sheer size of debt would soon test the generosity of
authorities. Banks may therefore need to raise even more capital despite
the results of the stress tests and regulators stating otherwise. In
overstretched countries, banks are also likely to face price wars to
attract depositors from each other, as is the case in Spain. There may
also be casualties unless banks decide to shrink, seek out a buyer or
break themselves up.

The tests, following on from a similar exercise in the US, may encourage
other regions to take similar action. India, whose banks emerged
remarkably unscathed from the global crisis despite a liquidity squeeze,
may test banks twice a year from now on, although it said it would not
make the results public, as was the case in Europe and the US. A senior
official told the Financial Times that the central bank had so far
conducted two stress tests on the country’s commercial banks, and had
undertaken several sector specific tests as well. Regulators have
acknowledged, however, that the country’s stress tests do need to be
more rigorous in the future, as they are currently easier to pass than
those conducted in Europe, which themselves had been described as weak.

Despite criticism that Europe’s stress test was too easy to pass, this
may have been necessary to produce the desired effect. Indeed, making
them more stringent could have caused unnecessary alarm. The purpose of
the stress tests appears to have been less about ensuring depositor’s
money was safe or that taxpayers would not be called upon again, and
more about reassuring banks and their shareholders that that they would
not be required to provide significant additional capital. But any form
of stress testing does not provide a guarantee against defaults. “If
there were another shock to the European system – for example, Spain
requesting assistance from the European Financial Stability Fund – then
these tests would be meaningless without a return to testing for a
sovereign debt default on the bank’s balance sheets as well as their
trading books,” suggests Mr Skinner. “That's the oversight this time and
if there is a next time, then this will be key.”

Providing a timely boost of confidence is an attractive short-term
outcome, although it may not open up funding markets to the level that
banks desire. This issue of funding could blight Europe more than any
other region, given its giant banks and high loan-to-deposit ratios.

But
officials from Germany’s regulatory board defended their banks, arguing
that local laws prevented banks from being forced to publish such
details. Mr Vossen at the CEBS did not comment directly on why Germany
had backed out of the agreement, although he did say that he would be
speaking with German authorities. The European Commission was keen to
back up the secretary general and said it would encourage the few banks
which had not disclosed the information to do so. Mr Vossen was also
quick to dismiss criticism of the tests themselves, insisting that they
would calm the market. In response, German banks reasoned that they had
not been under pressure by Germany to publish the information, and said
that if they had been asked by either authority – Bafin or the
Bundesbank – they would have obliged.   

Germany also has specific issues related to its banks’ leverage ratios,
particularly among its Landesbanken. Bafin admitted that state banks
could have as much as $1 trillion of toxic debt on their balance sheets.
Recent revelations over Deutsche Bank’s exposure to high levels of debt
raised eyebrows; its second quarter financial results revealed €54bn
worth of government debt for European countries – €4.4bn with Greece,
Ireland, Portugal and Spain, and two-thirds on its trading book. “Most
of this was undeclared in the stress tests, and the Landesbanken which
are of major concern, could therefore pass the stress tests when
technically they should have failed.  This is what invoked the major
criticism,” points out Mr Skinner.

Working in Germany’s favour is its medium-sized banks. They can borrow
at low rates as investors believe the state can guarantee rolling over
their debts. Such luxuries do not exist among nations with weak public
finances, such as Spain, or with supersized banking systems, such as
Britain. There, banks with major funding deficits are more reliant on a
market recovery, and hope they can ride out their debts until this
happens. But the sheer size of debt would soon test the generosity of
authorities. Banks may therefore need to raise even more capital despite
the results of the stress tests and regulators stating otherwise. In
overstretched countries, banks are also likely to face price wars to
attract depositors from each other, as is the case in Spain. There may
also be casualties unless banks decide to shrink, seek out a buyer or
break themselves up.

The tests, following on from a similar exercise in the US, may encourage
other regions to take similar action. India, whose banks emerged
remarkably unscathed from the global crisis despite a liquidity squeeze,
may test banks twice a year from now on, although it said it would not
make the results public, as was the case in Europe and the US. A senior
official told the Financial Times that the central bank had so far
conducted two stress tests on the country’s commercial banks, and had
undertaken several sector specific tests as well. Regulators have
acknowledged, however, that the country’s stress tests do need to be
more rigorous in the future, as they are currently easier to pass than
those conducted in Europe, which themselves had been described as weak.

Despite criticism that Europe’s stress test was too easy to pass, this
may have been necessary to produce the desired effect. Indeed, making
them more stringent could have caused unnecessary alarm. The purpose of
the stress tests appears to have been less about ensuring depositor’s
money was safe or that taxpayers would not be called upon again, and
more about reassuring banks and their shareholders that that they would
not be required to provide significant additional capital. But any form
of stress testing does not provide a guarantee against defaults. “If
there were another shock to the European system – for example, Spain
requesting assistance from the European Financial Stability Fund – then
these tests would be meaningless without a return to testing for a
sovereign debt default on the bank’s balance sheets as well as their
trading books,” suggests Mr Skinner. “That's the oversight this time and
if there is a next time, then this will be key.”

Providing a timely boost of confidence is an attractive short-term
outcome, although it may not open up funding markets to the level that
banks desire. This issue of funding could blight Europe more than any
other region, given its giant banks and high loan-to-deposit ratios.

About Chris M Skinner

Chris M Skinner
Chris Skinner is best known as an independent commentator on the financial markets through his blog, the Finanser.com, as author of the bestselling book Digital Bank, and Chair of the European networking forum the Financial Services Club. He has been voted one of the most influential people in banking by The Financial Brand (as well as one of the best blogs), a FinTech Titan (Next Bank), one of the Fintech Leaders you need to follow (City AM, Deluxe and Jax Finance), as well as one of the Top 40 most influential people in financial technology by the Wall Street Journal’s Financial News. To learn more click here...

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