The four most surprising things about the European bank stress tests

By Finance Addict

On Thursday the European Banking Authority released the results of the latest European stress tests showing a total capital need of €114.7 billion across 71 banks. While German banks might argue that they got the worst of the surprises, there are plenty more in store for everyone.

Surprise #1: They’re not actually stress tests.

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The European Banking Authority really prefers it if you use the term “recapitalization exercise”. Got that? From their FAQs:

Has the EBA conducted a new round of stress tests?

No. The EBA has not conducted a new round of stress tests.

Why do they insist on making what seems like a trivial distinction? This leads us to:

Surprise #2: This time the EBA did not look at how banks would weather a worsening economy.

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This is why they’ve re-branded the whole thing. I’ve addressed this crazy rumor before, but now it’s confirmed. Unlike what they did in the July “stress tests”, this time the EBA did not look at the banks’ ability to withstand an environment of higher unemployment, lower GDP and lower house prices, in addition to potential losses on their sovereign exposure. Despite ECB president Mario Draghi also confirming on Thursday what any idiot would already suspect: the European economy has “substantial downside risk” and “high uncertainty”. Despite the fact that the entire EBA exercise is meant “to provide a reassurance to markets about the banks’ ability to withstand a range of shocks and still maintain adequate capital.” Quite.

Surprise #3: The total capital need of €114.7 billion was greater than the EBA’s estimate from late October (€ 106 billion), but far short of the estimates that other analysts have calculated given the EBA’s Core Tier 1 target of 9%.

European Banks Capital Shortfalls

This could be for any number of reasons, including the above-mentioned failure of the EBA to include an adverse economic scenario. But it’s interesting to note that Citigroup and Credit Suisse, are much closer to each other than either is to Reuters or the EBA, itself. Given the politics of the whole exercise, and the EBA’s delicate position in all of this, which source seems more credible?

Surprise #4: The EBA has marked sovereign exposures to market using values as of September 30. It will give the banks until June 2012 to raise the extra cash but it will not recalculate the capital need, regardless of what happens between now and then.

The EBA has calculated what banks would need to raise to reach a Core Tier 1 capital ratio of 9% assuming that sovereign exposures were marked-to-market, not just in the available-for-sale portfolio but also in the held-to-maturity portfolio where the bulk of the exposures tend to sit. Kudos to them for this change–they took a lot of flak for ignoring the HTM portfolio last time around. That being said, it’s absurd to not consider how capital needs might change between now and the deadline for raising it. I understand why it’s tempting to build in such rigidity. Shareholders would love to draw a line under this and to hear, “That’s it, no more, we promise.”  But isn’t this also ridiculously short-sighted? After all, it was only this week that S&P placed 15 eurozone countries on review for potential downgrade, including all of those rated AAA. There’s now a very strong chance that these bonds will continue to fall in value. For instance, just look at how the yield on the 10-year French has exploded since then (moving inversely to price.)

French 10-year bond

Source: Bloomberg

Like the entire exercise this facet is meant to reassure but in fact may only make things worse.

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1 Comment
  1. Anonymous says

    This is either systemic fraud by banks as a result of overvaluing their balance sheet or serial incompetence from bank regulators who should have been keeping an eye on bank balance sheets and any potential problems. The end result is that tax payers were, and still are being impaled on the debt hook to protect the banks. This level of corruption is so significant that it extends to the leaders of all the EU nations that have supported bank bailouts. Even the UK coalition who were not in power when the bailouts were granted would not have changed them. This is still a banking crisis and until that is dealt with the sovereign crisis cannot even start to be tackled. 

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