SERIOUS MONEY:THE MUCH-awaited EU banking stress test results were released with much fanfare last Friday. The tests revealed that the European banking system is relatively well-capitalised and capable of weathering adverse shocks stemming from either a double-dip recession or elevated sovereign risk. Financial markets responded well to the results, though the entire process has been derided by many analysts as a sham.
The amount of disclosure and transparency was a welcome surprise, but the test itself was not particularly stressful and, as a consequence, the results are likely to be only a small step in returning the interbank market to normalcy.
The stress tests were conducted by the Committee of European Banking Supervisors in conjunction with the European Central Bank and national supervisory authorities. They were applied to 91 European financial institutions from 20 countries that combined, represented roughly two-thirds of the EU’s banking sector.
Just seven institutions failed the test, including five Spanish savings banks, Germany’s Hypo Real Estate and the Agricultural Bank of Greece. The number of stress test failures fell well short of expectations, as did the cumulative capital shortfall at just €3.5 billion, which begs the question – was the exercise far too lenient?
The test utilised macroeconomic assumptions that appear both reasonable and relatively stern. The adverse scenario envisages a double-dip recession, with EU GDP contracting by 0.2 per cent in 2010 and 0.6 per cent in 2011, as compared with baseline growth of 0.7 and 1.5 per cent respectively. This may not appear to be particularly severe given a GDP decline of more than 4 per cent in 2009, but it implies a cumulative output loss of roughly 6 per cent over a three-year period, which is sufficiently pessimistic on any measure.
The country-specific stress test assumptions for both commercial and residential property prices are relatively severe under the adverse scenario. Spain, for example, assumes a cumulative decline of 38 per cent for commercial property prices versus the base line that already assumes a significant price drop over the two-year period. The Germans assume a cumulative decline of more than 20 per cent for both commercial and residential property prices, even though the country never experienced an asset bubble.
So far so good, but unfortunately that’s as good as it gets. The adverse scenario for elevated sovereign risk included haircuts on five-year bonds at the end of 2011 of 23 per cent for Greek bonds, 14 per cent for Portuguese bonds, 13 per cent for Irish bonds and 7 per cent for Italian bonds.
These haircuts however, are applied only to the banks’ trading books, which are marked-to- market, and not to their banking books, where securities are assumed to be held to maturity. This seriously undermines the credibility of the test because the vast majority of sovereign bonds are held in the banking book and would only suffer a writedown if there was serious doubt about an issuer’s ability to repay.
Thus, the test simply dismisses the possibility of a sovereign default, even though market prices suggest that the probability of a Greek default is close to 30 per cent.
A further criticism is the focus on Tier 1 capital rather than common shareholder equity. Tier 1 capital includes both common shareholders’ equity and hybrid capital, which combines features of both debt and equity.
Hybrid debt instruments were issued in substantial amounts by European banks during the credit bubble, as a means to leverage their balance sheets without a detrimental effect on their credit ratings; hybrid debt instruments have also formed part of governmental support for the banking sector in several EU countries.
Given hybrid capital’s debt features that include a fixed payment stream, it is a questionable measure of strength. Had the stress test focused solely on shareholder equity, it is quite probable that the list of failing institutions would have been substantially larger than the seven banks reported. Indeed, all of the German Landesbank passed only because of the use of the wider definition of capital.
The stress tests did surprise with the level of disclosure and transparency, particularly in the case of the Spanish financial institutions. The Germans however, continue to drag their feet and adopt a contemptuous attitude that was apparent from the outset. Of the seven banks that have not disclosed their sovereign bond holdings, six are from Germany – Deutsche Bank, Deutsche Postbank, DZ Bank, Hypo Real Estate, Landesbank Berlin and WGZ Bank. One wonders what the five German institutions that passed the test are attempting to conceal.
The banking stress test is clearly a step in the right direction, but the low failure rate and aggregate capital shortfall confirms that the confidence-building exercise is less than convincing. The inclusion of a possible sovereign debt default was always a political non-starter, but the deliberate omission of such a credit event undermines the test’s credibility, while the use of a questionable definition of capital yields the estimated financing requirements unreliable. All told, the not-too-stressful test is unlikely to result in a significant easing of strains in the interbank market.
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