Bank stress tests are a game of extend and pretend

Mario Draghi, president of the European Central Bank, was admirably honest this week when he admitted that some banks are going to have to fail the next round of stress tests if the process is to have any credibility. But in saying this, he has given the game away. Previous stress tests utterly failed to identify the weaknesses here and in the periphery, not because the testers were idiots but because the truth about the state of Europe's banks was simply too awful. It still is.

So, some more banks will have to be sacrificed – told to raise capital – to try
and inject some credibility into a very tricky process.

The name of the game is extend and pretend. The longer the losses sitting on bank balance sheets can be hidden, the more chance there is that the passage of time will gradually shrink the size of the problem. That’s the plan at least. To a greater or lesser extent, most European countries have a banking problem. The trouble is that these difficulties are too easy to hide – until they overwhelm us, often overnight with little warning (from stress tests at least).

One clue about the magic ingredient of time is to be found in how long the next stressful exercise is going to take: a full year. I am tempted to say that it isn't really that complicated. A decent banking analyst supported by some recently minted MBAs armed with the appropriate software could do all this in weeks –
using publicly available information.

As with most things European these days, Germany sets both the agenda and the pace. Top of the agenda is a rule: no German taxpayer money for future bank bailouts. Second is the need to give parts of the German banking system the best part of the next century to get balance sheets in order – that time thing again. The state of Germany's banks doesn't really matter, for now at least, since the economy is fine.

Of course, impaired banks are a bigger problem for the rest of us. It is getting tedious comparing the cleaned-up US banking system with Europe’s mess. But commentators are wrong when they rage against the supposed lunacy of Europe’s slow-motion policies.

Who pays?
The reality is that only one question matters: "who pays?" In the US it was a combination of bondholders, taxpayers and shareholders. All quite rational – and straight from the banking crisis playbook. Europe has yet to decide who pays. But we know who doesn't want to pay.

Running in parallel with the stress tests is the battle over the future of banking regulation and resolution. Which is another way of asking our simple question, “who pays?” Because we are still nowhere near being able to provide an answer, there is no point pretending we can quickly do what the US did. Sensible pilots circle the runway while it is clouded in fog.

Good lawyers never ask a question to which they don’t know the answer. Draghi is, I suspect, playing the same game. The answers to the forthcoming stress tests are almost certainly sitting on a USB stick securely locked away in the vaults of the ECB. All of the vested interests need to keep this particular show on the road. I will be astonished if the results of the tests have not been choreographed well in advance.

The truth is we don't know how much more capital banks really need. But we do know (without the need for yet more stress tests) the shape of the answer: a lot more. How much more depends. Several independent observers of global banking have concluded the only way we can stop the banks from ever blowing us up again is to massively increase their capital buffers –
to well in excess of anything the ECB tests are assuming.

Fear of crisis
Again, there is no point in insisting that Europe's banks raise a lot more capital any time soon. The weakest banks are hooked on state support, despite promises the sovereign credit rating will be divorced from the banks. In the current set-up, if large swathes of the banks are deemed
by Draghi's tests to require lots more
support, the only place it can come from is from near-insolvent governments. A bad outcome to the stress tests will simply kick off the euro zone crisis again. Hence, there cannot be a bad outcome. But the banks will, one day, need a lot more capital.

Between now and then – the day our simple question is answered and someone writes a very big cheque – the system will remain impaired.