As widely expected, the much-ballyhooed stress tests on 91 European banks turned out to be somewhat less than stressful. And while some information is better than none at all - which has long been the Europeans' preferred operating style - it's hard to see the results persuading any sane onlooker that the financial sector has been fortified enough to withstand serious future tremors.
Of the seven small, struggling banks that flunked, two of them, Germany's Hypo Real Estate Holding and Greece's ATEbank, are already in the hands of their respective governments. The other five, one of which has already been taken over, are unlisted Spanish savings banks that got hammered when the country's real estate bubble burst.
Another dozen banks barely scored a passing grade and will undoubtedly need further injections of capital, while the rest were all deemed to have a comfortable enough cushion to weather the adverse scenario designed by the Committee of European Banking Supervisors. This is undoubtedly accurate. Banks across Europe have been bolstering their core capital for months. If they can't handle the modest double-dip recession and sovereign bond haircuts posited by the regulators, the entire global financial system is in even deeper trouble than we thought.
The testing bar was set so low that it was akin to one of those notorious exams once administered to star athletes at certain American colleges: Spell both your first and last names right and get a pass in English 101.
In the worst-case scenario conjured up by the Europeans, banks had to show they could handle a slightly weaker economy, with no growth this year, a decline of 0.4 per cent in 2011 and a rise in unemployment to 11 per cent. Heck, for Greece and Spain, that would constitute a banner year.
The examiners also factored in a 20 per cent drop in equities and a steep rise in financing costs after a 23 per cent decline in the value of Greek bonds and another 12 per cent on Spanish debt. But only bonds on banks' trading books were included in the calculation, not the much larger holdings in the banks' own coffers. And the possibility of an outright default by one of Europe's basket cases was not even considered.
Ignoring the whole issue of default shows the stress tests "are essentially suffering from political correctness," Mark Cliffe, ING's chief economist, said during a stopover in Toronto. "If it's a stress test, you have to count this, because the markets are at least part way to discounting this possibility, certainly in the case of Greece."
The Eurocrats also studiously avoided another possible nightmare, however unlikely - the collapse of the euro. Mr. Cliffe and his staff have done that work for them, assessing not whether such a market-shattering event is possible, but what the implications would be.
They chose two of the numerous possible permutations at each end of the scale - an orderly exit by Greece alone and the complete disintegration of the common currency.
In the first case, the ING study calculates Greek GDP would plunge by 7.5 per cent in 2011 and other euro zone countries would see declines of up to 1 per cent. The euro itself would slump to 85 cents (U.S.) and credit spreads would widen, though not on the scale of what occurred during the global credit freeze.
A breakup of the euro zone, though, is a radically different story. The result could be a deep recession that would spill over into Britain and eastern Europe and drag down the global economy. The weaker euro countries would see their new currencies drop off a cliff. Spain, Portugal and Ireland would devalue their currencies by 50 per cent against a restored German mark. Italy would drop 25 per cent and France 15 per cent. Stocks would head south, and the weaker countries would be hard-pressed to contain capital flight. Some weaker economies could be facing double-digit inflation, while deflation would be the main headache for the stronger European countries (and even the U.S.). Banks would be exposed to heavy credit losses.
Now that he has quantified the unthinkable, does Mr. Cliffe actually think it could happen?
"The probability is less than the consensus opinion on this," he says. So why bother assessing the impact of such an unlikely event? Because it's no longer merely "a subject for fevered Anglo-Saxon imaginations," he says. "It is actually something now that is being openly discussed within the euro zone itself."
Mr. Cliffe acknowledges "the numbers that we pulled together are debatable, contestable and heavily contingent on the assumptions that we have made. But nevertheless, we thought it was important…to have a go at this," he adds. "It's dirty work, but somebody's got to do it."
The same could be said for the European bank stress tests. Too bad the examiners didn't use bigger shovels.
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