European Central Bank present Jean-Claude Trichet. Many banks, especially in the troubled peripheral sovereigns, are now dependent on funding from their own central bank or the European Central Bank.Mario Vedder
Satyajit Das is a global risk consultant and author. His latest book, Extreme Money: The Masters of the Universe and the Cult of Risk , will be published in August.
The results of the European Banking Authority (EBA) stress tests on European banks have been over shadowed by other momentous events -- the announcement by the European Union (EU) of a range of measures to deal with the European debt crisis.
For the record, only 8 out of 90 European banks tested "failed" the 2011 test, meaning that they did not have the required 5 per cent level of capital in a stressed scenario. Their capital needs were estimated at around €2.5-billion ($3.6-billion). Another 16 banks were deemed vulnerable, being within 1 per cent of the minimum required capital level. Highly stage managed and contrived, the latest stress test has done little to build confidence, instead exacerbating uncertainty and doubt.
The most significant deficiency was in relation to bank holdings of sovereign debt. For Greek bonds, this loss under a stress scenario was a mere 15 per cent loss. This was below the actual market losses of 50-60 per cent implied by current market prices for Greek bonds or the 21 per cent loss where banks roll over Greek debt under the new bailout package proposed. Similar problems exist with the Irish and Portuguese bonds where market prices imply losses around 30-40 per cent. The test results may significantly underestimate losses if Greece, Ireland and Portugal default and the Spain and Italy experience serious financial pressure.
The modest assumed drop in growth and rise in unemployment contrasts with the sharp contraction in economic activity and employment seen in the peripheral European economies. Standard stress conditions unadjusted for specific national conditions are analogous to achieving an acceptable average ambient temperature by placing one's feet in the oven and head in the refrigerator.
The interaction of the individual stress factors, the so-called "knock on effects", are crucial. In the first phase of the global financial crisis, major problems were caused by negative feedback loops starting with loan losses, distressed banks, freezing up of money markets, cessation of lending and macro-economic effects (reduced growth, higher employment, slowdown in trade) which then set off new cycles of instability. The non-incorporation of "second order effects" is a serious deficiency.
Financial systems rely on the implicit support of national banking systems by the sovereign. As highlighted by the global financial crisis, financial institutions are "too big too fail." This assumes the ability of sovereigns to support their banks, should it become necessary. Many euro zone countries are in no position to support their banks. A stress test of European banks is meaningless without a parallel assessment of the ability of the sovereign to support the bank.
The stress tests also focused on the banks' assets. The trigger for bank problems is usually the inability to finance themselves in the money markets -- the "run on the bank".
Many banks, especially in the troubled peripheral sovereigns, are now dependent on funding from their own central bank or the European Central Bank (ECB). According to market estimates, the ECB has provided up to €400-€450-billion in financing, including €240-€250 billion to the bailout nations. The stress tests did not assess the banks' ability to withstand continued funding pressures.
Europe seems unable to grasp the seriousness of the situation and deal honestly with its financial problems. There are media suggestions that the EBA preferred a stronger stress test but was constrained by political and banking pressures. There were even suggestions that national central banks failed to provide EBA with accurate data. The UK Telegraph quoted the EBA Chairman saying that: "figures given by the banks in some cases 'materially' changed after being challenged".
The stress test's objectives were laudable: (1) to strengthen the financial system by forcing banks to hold adequate equity, and (2) to convince markets about the solvency of European banks. Unfortunately, the deep flaws of the stress test mean that they failed both objectives.
When the expected European sovereign debt restructurings occur and the effects on the real economy become evident, European banks and regulators will still need to pass the only test that really matters. Whatever the stress tests say, the real test still lies ahead. Given events of recent days -- perhaps sooner than most people think.