Given the shaky macroeconomic risk assumptions and rather apparent gaps in valuations of some banks' assets, the Spanish stress tests published last Friday could best be described as an attempt to match the expected aggregate capital shortfall to the €60-billion figure that Madrid committed to in advance of the tests. As such, this appears to be a cynical exercise in buying time before the EU can put in place the array of promised measures to fund the Spanish government and its banks.
Failure by the auditors to account for the effects of the adverse shocks to stock market valuations on some bank holdings of listed equities, which were well-flagged in analysts' reports, is one of the possible sources of the risk underestimation. Another source: the benign assumptions (compared to what has already materialized) on unemployment in 2013-14 and expected property price declines over the test period.
Mostly omitted by the analysts, there is an additional problem of the stress tests attempting to steer the focus away from dealing with the long-term nature of the crisis. As history suggests, balance-sheet recessions of the type experienced by Spain last much longer than the six years implied by the cut-off date of 2014 used in the stress tests. In benign cases, these crises can take 10 years on average to run their course. In less benign circumstances, two to three decades seems a more likely time frame.
All of these shortcomings, however, pale in comparison with the fact that the tests of the Spanish banking system's health appear to have largely neglected the risks associated with the banks' vast holdings of Spanish government bonds and their exposure to the ECB funding. The assumption is that government bonds can either be sold or collateralized to raise funding for loan writedowns. The problem is that, under stress, raising such capital will require significant discounts on bond valuations. The greater the banking system stress, the deeper the discounts.
On the other hand, the stress testing covers a period during which extraordinary ECB bank liquidity measures will continue to apply. Come mid-2013, some €1-trillion of funding will be hitting the markets across the euro area, as the ECB's long-term refinancing operations begin to unwind. If disposal of Spanish banks' assets coincides with this, the banks will not be able to raise much of the required funding in the markets against their holdings of Spanish government debt.
This means that the asset cushion available to the banks is overstated by the stress tests, while the expected losses and demand for non-ECB funding are understated. The stress tests seem to avoid the pesky issue of liquidity risk related to Spanish banks' sovereign debt exposure. By the end of 2012, Spanish banks and financial intermediaries are expected to hold some €270-billion to €280-billion in government bonds, all collateralized against €412-billion worth of ECB borrowings (through August, 2012). Some of the banks have also borrowed significantly from central banks in countries where they have sizeable operations. This implies a major potential headache for the Spanish banks, if the ECB (or central banks outside the euro area) were to force the unwinding of the extraordinary liquidity funding measures.
Taking into account the risks outlined above – and allowing for more realistic declines in Spanish employment and property prices – the real demand for capital in the financial system will be closer to €100-billion to €110-billion through 2015-16. One can only hope that between now and 2013, the EU manages to put together a credible long-term fix to cover the banking hole that is Spain.
Dr. Constantin Gurdgiev is adjunct professor of finance at Trinity College, Dublin