ANALYSIS:The ECB must use severe scenarios for the tests to be credible, but that will increase the likelihood of fresh capital injections, writes ARTHUR BEESLEY
THE EUROPEAN authorities face yet another moment of truth tomorrow evening when the results of financial stress tests on 91 leading banks are published. This is tricky stuff, with tens of billions of euro on the line and no guarantee of success.
The exercise was designed to instill confidence in Europe’s banks by lifting unfounded suspicion from institutions that have the strength to weather the twin pressures of general economic distress and threatened sovereign default. By going down this road, however, EU leaders have invited searching questions about their own resolve to overcome the financial emergency.
On the face of it, this is something of a no-win bind for them. A stress test on a bank is essentially a health check to gauge its capacity to withstand adverse trends such as a rise in bad loans or lower economic growth than expected. In the present examination, with the capacity of Greece to find secure financial footing without debt restructuring still in doubt, the assessment of sovereign risk is crucial. So too will be the assessment of loss scenarios in relation to property loans.
Here is the dilemma. If the tests are predicated on severe scenarios, European governments would have to inject yet more money into the banking sector. Less money would be required if the scenarios are lenient, but the exercise would then run the risk of being self-defeating: damaging confidence instead of boosting it.
The truth is that neither option is appealing. Credibility is key, however, as the stress tests represent but one strand of a huge effort to keep the financial crisis at bay. Found wanting in their halting response to the Greek debacle, Europe’s leaders faced down a dire threat to the euro when they created a €750 billion lifeline with the IMF for any other euro country that might need help.
Having won a measure of calm from the markets, the last thing they want now is to throw oil on the embers. But the exercise remains shrouded in uncertainty and speculation. Even as senior bankers descended on Frankfurt yesterday for meetings with European Central Bank chief Jean-Claude Trichet, the exact parameters of the tests remained in some doubt.
This is at odds with similar tests on US banks last year, which helped dampen fears that big-name lenders such as Citigroup and Bank of America might have to be nationalised. Whereas US regulators made public a detailed description of their examinations well in advance of the results, EU finance ministers have haggled for weeks over the scope of the European exercise.
The reason for this is political, governments being on the hook for fresh capital if private investors do not step forward with money for institutions that fail the tests. This cuts to the core of the problem raised by stress testing – and the scepticism that still surrounds the initiative in markets.
Then there is the question of funding any new bailouts. Even though economics commissioner Olli Rehn has raised the prospect of the euro zone rescue net being used as a last resort to help governments buttress their banks, officials say this can only be done indirectly as part of a wider stabilisation programme for the country in question. That is a rather unappealing prospect for any government, with huge potential for controversy in the countries that fund the rescue net.
So what will be tested? The latest information suggests banks must estimate how much more capital they might need to achieve a 6 per cent Tier 1 capital ratio, a key measure of financial strength, under two adverse scenarios and a base scenario.
First, they must estimate this ratio at the end of 2011 under an adverse scenario including two years of economic deterioration.
They must then make the calculation in an adverse scenario with an “additional sovereign shock”. In such cases banks must estimate sovereign debt losses on paper in their short-term trading book and additional impairment losses on sovereign paper in their banking book, in which assets are typically held to maturity.
While the inclusion of both books serves to broaden the scope of the examination, doubt remains over the severity of scenarios set out for individual issuers of sovereign debt.
Still in question is the assumed discount or “haircut” on the principal sum in any default by individual sovereigns, its implications for “sub-sovereign” debt issued by public authorities in the same country and its implications for corporate debt. Also in question is whether the test criteria are consistently applied across the 20 countries that are participating in the exercise.
The more consistency and transparency the better, but the greater the likely need for fresh capital.
At issue for the Government is whether Allied Irish Banks (AIB) and Bank of Ireland (BoI) will need capital in addition to their projected requirements following the transfer of property loans to the National Asset Management Agency (Nama).
Despite some doubt about the prospects of the “big two” among certain international analysts, Minister for Finance Brian Lenihan has argued that both institutions have undergone more rigorous stress tests at home and should have fewer problems in the European examination than other banks. To get to this point, however, AIB and BoI have already received significant State aid.
Lenihan is not alone in his confidence. Officials and bankers from countries including France, Greece, Belgium and Austria have said their lenders will pass the tests. To one degree or another, such certitude has only fuelled anxiety that the examinations will be too weak.
German sources have also expressed confidence, despite expectations that commercial property lender Hypo Real Estate will fail the test.
Hypo was rescued by the German government after the eruption of the financial crisis. The problems do not end there for Chancellor Angela Merkel. According to Barclays Capital, Germany’s Landesbanks may need no less than €34 billion.
The needs of Spain’s cajas may be in the order of €36 billion, adds Barclays Capital, and Greek lenders may need €8.6 billion. While these are widely held to be the most vulnerable, there remains ample scope for surprise. The results will be released after markets close tomorrow evening. It is only over the weekend that the merits of the exercise – or otherwise – will become clear. The stakes are rising.
Arthur Beesley is Europe Correspondent