“Serenity now!”
Although the famous quote may have worked for Frank Costanza from the popular sit com Seinfeld, the EU banking sector is going to have to say a lot more to instill confidence in its ailing economy.
The top ninety-one banks that account for roughly two-thirds of the banking assets in Europe passed the stress tests that were conducted later last week. I would have had absolutely no reservations in betting my mortgage on the results of the European stress test being positive. This is not because I have undying faith in the economy, but because a positive result was expected. Stress tests would not have been announced if a bunch of banks were in the position to fail. The purpose of conducting the stress tests was to instill confidence, not ruin it.
I am not entirely sure if that goal was achieved. The Wall Street Journal has a well thought out article discussing the stress tests conducted by European regulators . The article asserts that the scenarios were not tough enough to give a true picture of whether or not the banks could survive a double dip recession. If you do not like to read (which would be ironic as you are reading a blog at the moment) the graph at the end of the article says it all – it shows a huge cluster of banks barely making the 6% tier one ratio requirement. Therefore, though only seven banks failed, there are a boat load of banks teetering at the brink of failure. The article covers some good points for both sides of the argument but does not really touch upon the issue that I have with the tests.
All this talk about ‘transparency’ and getting ‘insight into Europe’s banking’ is fine and dandy, but it seems like a classic case of not looking at the real issue. My beef with the test, aside from the fact that the rules were not stringent enough, is quite simple: the tier one ratio itself can be massaged to a great degree (much like a discounted cash flow valuation). Since the essence of tier one is to measure a variation of a shareholder’s equity to risk adjusted measure of assets, trying to ascertain what the “correct” risk weighting of the assets is open to subjective judgment.
Second, the Sovereign debt issue which is a huge threat to the EU was out of scope of the stress test. Spain is currently plagued with a huge number of over levered banks due to its property crisis. Not taking sovereign debt into account is like focusing on losing 15lbs but ignoring your soaring cholesterol level. Yes it’s a good goal, but it’s not going to lower the risk of a heart attack. I am not advocating that the stress tests should be scrapped, but they should not be considered a harbinger of things being OK at the moment. I do not expect anything drastic to happen in the next year or two since the crisis is still fresh. However, once the IMF and EU tighten their pockets and local governments funds start to dry up, sovereign debt will be a big issue for European banks as well as the Global economy.
P.S. Food for thought: here is an article on Bloomberg discussing how the European debt market, specifically German bonds may take a hit as a result of the the stress tests in Europe. Lets see how the next week pans out.
