Nicolas Véron

Europe's Stress Tests: Only One Step Toward Banking Repair

This article was published by eurointelligence as well as on the websites of Bruegel and PIIE. Translations were published by La Repubblica (Italy), Kathimerini (Greece), Caixin (China), FT Deutschland (Germany) and La Tribune (France).

The European banking “stress test” results announced on July 23 combined encouraging features with disappointing ones, which explains the paradoxical mix of reactions: markets rose, even as many analysts denounced what they saw as a sham. Their publication is unlikely to single-handedly bring the interbank market back to soundness. But it may prove an important step, depending on what policy initiatives come next.

On the plus side, there is unprecedented data on sovereign risk exposures, individually and consistently reported by all tested banks except one Greek and six German institutions. The wealth of information adequately addresses investors’ biggest current concern. After having repeatedly called a sovereign default out of question, the authorities could not include one in their stress scenarios, but they have done the next best thing, as analysts can now do it in their place. Further good news is that, on first analysis, a Greek default would appear potentially manageable.

Also positive is that, for once, peer pressure has brought results. Spain effectively imposed transparency to reluctant fellow continental countries (the UK, Ireland and the Nordics were already ahead), apparently with substantial behind-the-scenes help from the European Central Bank, International Monetary Fund, and US Treasury. The whole process illustrates that some EU-wide systemic financial problems can only be addressed through EU-wide policy initiatives, a useful lesson for the future. Meanwhile, the Committee of European Banking Supervisors (CEBS) has proven its value added by steering the exercise within the imposed deadlines.

Sadly, bad news abounds too. The most obvious is the conclusion that only €3.5bn of additional equity would be sufficient to make Europe’s banking system sound again. Few will find this credible, even allowing for the improved macroeconomic environment since the US stress tests of May 2009 had identified a $75bn capital shortfall. The tests’ focus on Tier 1 capital, a questionable measure of strength, is also regrettable, and the argument that other ratios are insufficiently harmonized fails to convince. Supervisors should have tested core tier 1 under a more severe adverse scenario, to compensate for their assumption of no sovereign default. Furthermore, they should have provided more disaggregated information by asset class to shed light on risks other than sovereign. On these, the EU disclosure format is much less comprehensive than those used by the US last year, or by Spain on its own initiative.

The poor communication ahead of the disclosures is another negative. On 17 June, EU leaders rushed to the decision to publish test results without realizing that their end-July deadline was far too short given the complexity and diplomatic haggling involved. It would have been far better to set the deadline in September, and leave more time for coordination and preparation. Even after the deadline of July 23, 4pm GMT, CEBS could not make it clear that exposure to sovereign risk would be disclosed on a country-by-country basis, leading to unnecessarily negative first reports. This stands in stark contrast with the masterful channeling of market expectations by US authorities throughout late April and early May 2009.

Of perhaps more lasting concern is the absence of a clear commitment from the EU authorities to the data disclosed last Friday. Both CEBS and the ECB made it clear that the capital assessment belonged to individual national authorities. Respect for member states’ sovereignty is understandable, but it means that nobody actually stands for the full set of disclosed numbers.

Last but not least, Germany appears still in denial about its domestic banking crisis. Beyond the legal arguments, German authorities dragged their feet, resisted the call for disclosure, and eventually failed to deliver the full numbers provided by almost all others. Behind the bureaucratic inertia lies a deeper political quandary: German leaders have made too many proclamations of Teutonic virtue against shadowy Anglo-Saxon speculators and profligate Southerners to recognize that there is rot in the middle of their very own banking system, which incidentally happens to be uniquely interdependent with local party elites, left and right. As long as Chancellor Angela Merkel and her team do not amend this stance, Europe is unlikely to get rid of its lingering financial fragility.

Ultimately, history’s verdict will depend on what happens now. First, Europe’s banks still need to raise more capital, and authorities must find a way to encourage this even after having ostensibly given them a clean bill of health. The trigger for the publication was the eurozone sovereign crisis, and the aim remains to make the banking sector resilient enough to sustain a possible future public debt restructuring. Second, fragile eurozone countries must continue their efforts towards sustainable fiscal consolidation, so that if one eventually defaults, others can resist the contagion pressure. Third, it is crucial for the EU to replace the fledgling CEBS and similar committees on insurance and securities with more authoritative European Supervisory Authorities, as recommended last year by the Larosière Report. It would be disastrous if the ongoing discussions ended in stalemate. But, should adequate progress be made along these three dimensions, then the publication of stress test results may be judged to have been a success after all.

Click here to download a PDF version.

Transparency is the key to stress-test success

This column was first published by eurointelligence, as well as translations in La Tribune (France), FT Deutschland (Germany), Boersen (Denmark), La Repubblica (Italy), Kathimerini (Greece), and Caixin (China).

By agreeing to publish stress-test results for the EU’s most prominent banks, European leaders have made a bold step that is both indispensable and ridden with execution risks. Even as the announced date of publication, 23 July, is approaching fast, several key aspects remain under discussion. For this unprecedented effort to be successful, a high level of transparency will be needed in order to force divergent national players into a consistent and credible process.

In the past, the key to resolving most systemic financial crises has been a system-wide “triage” of the most important financial firms, steered by public authorities and allowing market participants to identify which banks are strong enough to be relied upon – as in the US in 1989-90, Sweden in 1992-93, or Japan in 2002-03. The same arguably occurred in the US last year, when the publication of detailed stress-test results for 19 large financial firms helped the gradual return of trust.

The EU has long stayed deadlocked in refusal to address this need. Stress tests were conducted in September 2009, but with no quantitative data published the market effect was minimal. Only last month were EU leaders eventually prompted to action by a combination of market pressure, encouragement from the US and other outside parties, and Spanish leadership. The number of banks tested, initially set at 25, has been expanded to 91 banks from 20 countries, a welcome change given the large role banks play in financing the economy in Europe, which means that more must be assessed than was the case in America.

But many doubts linger, primarily because of the large number of players involved. In the US, only the Federal Reserve and two other federal regulators were at work under the mandate given by the Treasury Department. In Europe, each national authority has powerful incentives to protect “its” banks and sugar-coat the results, including reluctance to acknowledge past supervisory failures, capture by local interests, and economic nationalism.

This obstacle could have been overcome by centralizing the triage process and entrusting it to a supranational body with a temporary mandate, as Adam Posen, now of the Bank of England’s Monetary Policy Committee, and I had suggested in a paper published a year ago. However, this is not going to happen, at least not in this round. Thus, a disciplining device is needed to match national authorities’ impulses not to cooperate.

The best way to reach this aim would be a high level of quantitative detail in the disclosure of results. This would compel regulators to base their conclusions on testable facts, and would go a long way towards preventing them from manipulating the numbers. After a string of supervisory failures, the credibility of many of the authorities that will carry out the stress tests is at a low point. Transparency is the key if they are to convince investors and the public that their pronouncements can be relied upon.

Specifically, the results must allow external observers to understand the banks’ exposures to several different and relevant risk factors. In the US disclosures of May 2009, 17 quantitative parameters were provided for each of the stress-tested banks, including individual exposures along 8 different asset categories under a single, uniform template. At least as many line items should be provided in Europe, also under a single template that must apply uniformly in all participating countries.

As regards eurozone sovereign risk, which is central to current market concerns, it is understandable that authorities are uncomfortable with including national defaults in their stress scenario while they otherwise insist that none is going to happen. But rather than factoring in implausibly low discounts on troubled countries’ sovereign debt, as recent press reports suggest is their intention, they should disclose each bank’s exposure to each country risk, with due measures to ensure this does not result in instability in the period leading to publication. On this basis, market participants could use the data to test their own scenarios, and identify which banks are strong enough to withstand them.

The European decision to publish stress-test results is momentous. If its outcome is to be credible, it will necessarily reveal significant capital shortfalls in a number of banks. Otherwise, the gap with market perceptions, anecdotal evidence, and past top-down assessments by the International Monetary Fund and European Central Bank will be impossible to reconcile, and will increase market distrust and volatility. Not all the subsequent funding needs to come from the public purse. Last year, those US banks whose stress test indicated insufficient capital were able to convince market investors to plug the gap. Many European banks may succeed likewise. But if some fail, government intervention and restructuring will be indispensible, which is sure to prove politically controversial and financially painful.

These risks can only be managed if the stress-testing process is seen throughout the EU as comprehensive and fair. To ensure such fairness, a high level of detail in the disclosure of results, forcing national regulators to justify their eventual assessment of capital positions on the basis of facts not opinion, is a necessary condition.

Click here to download a PDF version.

Bank Stress Trests in Europe

Steve Weisman interviewed me at the Peterson Institute this week on the recent decision to publish the results of banking stress tests in Europe in July.

Click here to listen to the podcast interview.