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More on the Coming European Bank Stress Test Fiasco

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We noted a bit more than a week ago that we expect the European banks stress tests to backfire. The US version was a successful con game because the officialdom provided adequate disclosure about the process and stayed firmly on message, the banks were allowed to “manufacture” as analyst Meredith Whitney put it, impressive earnings, putting a tail wind behind their stock prices, and there was a mechanism for the US to inject capital if banks who were directed to raise equity levels were not able to do so.

We pointed out these conditions were not likely to be operative in the case of the Eurobanks, with the most obvious likely gaps a unified strategy among European leaders (this has been notably absent so far; why should the banks be any different?), doubts about whether there is enough “stress” in the stress tests (due either to insufficient transparency or overly generous macroeconomic assumptions), and most important, lack of a credible equity injection mechanism. In Germany, perceived to be the strong man of the EU, the size of its banking sector is so large relative to its GDP as to raise doubts about its ability to backstop its banks. Moreover, the German population is dead set against further bailouts.

Today, the Financial Times reports that the stress tests will be conducted on 100 banks, with details that were not encouraging:

The number of European banks subjected to stress tests is likely to rise, with sources suggesting that as many as 100 institutions will be involved in a broader exercise to shore up market confidence.

European Union leaders have already agreed to publish stress test results for 26 banks next month – mainly big, cross-border institutions – to address concerns about the eurozone’s exposure to sovereign debt.

But one German government official said those tests, which are being conducted by the Committee of European Banking Supervisors (CEBS), would be expanded to cover “significant market share” in each market – about half of all bank balance sheets in each country.

While the total number of financial institutions to have stress tests published remained open, the German official also said the country’s eight Landesbanks had agreed to publication.

The weakened Landesbanks had resisted publication until now, arguing that testing their ability to withstand sovereign defaults would send the wrong signal to bond investors.

The German government had supported this line but has come round to viewing publication as a potentially important confidence-building exercise.

Yves here. How pray tell do you “build confidence” by exposing the dirty laundry of sick banks? Pretty much everyone knows the Landesbanken are in bad shape.

We had also warned that coming up with credible stress levels would be problematic. Given the wide differences in economic performance among the eurozone member nations, it would make sense for each country to set its own metrics. But then you would need to have them trade notes and recalibrate, possibly renegotiate (since one country adopting tougher relative standards could make the rest look bad).

Instead, the eurozone appears to be adopting a “one size fits all” standard, which is not credible:

CEBS has said the parameters were being set at a pan-European level, despite suggestions from several banks that have been tested that the stress scenarios were nationally specific.

In a limited exercise last year, CEBS said its stress scenario involved a 2.7 per cent fall in GDP this year and 12 per cent unemployment.

Yves here. Ahem, unemployment in Spain is already at 20%. So we are seriously going to set the stress test level at 12%? No wonder the Spanish banking minister was so keen to publish results (I assume the test on Spanish banks was less nonsensical, but I could be wrong here).

The story indicates that analysts are already skeptical:

But one top banker said that even if the list were expanded it would not serve the purpose of sufficiently reassuring the markets. “You need total transparency,” he said. “You need to publish the results of the entire banking system – otherwise, suspicions will remain.”

Wolfgang Munchau, in a Financial Times comment (hat tip readers Don B and Swedish Lex) raises more general concerns about ongoing efforts to shore up the eurozone. The first part of his piece describes a staggering gulf in perceptions: eurozone officials who genuinely believe their salvage operation is going well, versus investors who see continuing disarray, last minute expedients, a failure to address significant, fundamental issues, and therefore see a breakup as inevitable.

Munchau turns to the the stress tests as what he expects to pan out as another example of poor planning and undue optimism by eurozone polcymakers:

I only hope that they know what they did when they recently announced the publication of the stress tests for 25 banks. Once these are published, the markets will immediately demand to see the tests for all banks. Once that happens, in turn, governments will need to produce a convincing recapitalisation strategy. I fear, however, that they are once again committing themselves to going down a road without a map.

Without an endgame, this exercise will end in disaster. At some point the markets will realise that large parts of the German and French banking systems are insolvent, and that they are going to stay insolvent. You might think that Europe’s policy elites cannot be so stupid as to commit themselves to stress tests without a resolution strategy up their sleeves. But I am afraid they probably are. Europe’s political leaders and their economic advisers are, for the most part, financially illiterate.

Is there a way out? Yes there is, but the chance of a resolution to the crisis is starting to fade. The first step would have to be a serious attempt to resolve bank balance sheets. This is as much a German and French banking crisis as it is a Greek and Spanish debt crisis. You need to resolve both problems simultaneously. Resolution would require a large fiscal transfer, not from Germany to Greece, but from the German public sector to the German bank sector – in the form of new capital. The same would apply to France.

Beyond this restructuring, the eurozone will need to commit itself to a full-blown fiscal union and proper political institutions that give binding macroeconomic instructions to member states for budgetary policy, financial policy and structural policies. The public and private sector imbalances are so immense that they are not self-correcting. And you have to be very naive to think that peer pressure is going to resolve anything.

There is no point in beating about the bush and issuing polite calls for the creation of independent fiscal councils or other paraphernalia. This is not the time for a debate on second-order reforms. I am aware that, at a time of rising nationalism and regionalism throughout the EU, there is no consensus for such sweeping reforms. But that is the choice the EU’s citizens and their political leaders will have to make – a choice between reverting to dysfunctional and, as it transpires, insolvent nation states, or jumping to a political and economic union.

Yves again. Munchau is clearly not optimistic that EU leaders recognize the magnitude of the challenges to achieving a better union. Not only has wearing rose colored glasses blinded them to the difficulties before them, but it has also led them to fail to prepare their citizens adequately. That almost assures a popular backlash even if the officialdom were to get religion late in the game.

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9 comments

  1. Diego Méndez

    Disclosure always brings forward confidence. If you hide something, people will always expect “extend-and-pretend” policies and will set up for the worst.

    (As an aside, I don’t think European supervisors are stupid enough to make tests on a 12% national unemployment level basis. They *must* have used another method.)

    On capital injections: right now, the banks in worst shape are usually said to be Spanish Cajas and German Landesbanken. I don’t know about Germany, but Spain (which is in a frenzy-reform mode, with people demanding reforms that make politicans share the pain) has plans for private capital-injections into Cajas (in addition to public capital injections, if needed).

    Public capital injections could be drawn from a specific banking-crisis fund (which has been funded for decades through a tax on banking). The law on Cajas is planned to be reformed in the short term so as to effectively privatize these public entities, thus re-capitalizing them. More importantly, that would take Cajas away from politicians’ (and even Catholic priests’) dirty, unexperienced hands…

    [A cynic would add: and into the dirty, experienced hands of banking crooks].

  2. Hubert

    As always Munchau seems to have the solution. As Sicily does not take orders from Rome, Greeks do not care about Athens tax rules and Belgians look on the verge of splitting up – now we need to firm up the ultimate layer of idiotic bureaucracy and corruption on the European level.
    Sure, in the beginning the EU was some positive force to prune local rackets but these days are gone now. Lobbyists are firmly entrenched now in Brussels. As Washington has ceased to be a positive force on the US long ago, Brussels unelected state officials do more damage now than good.
    How can well-minded US citizens recognize Washingtons dysfunctions and long for an even bigger racket containing people who speak over 50 languages ?
    Recently Charles Gave (father, NOT son) published an really important essay about the subsidiarity concept of Europe. Anybody who wants to retain some liberty on the old continent should abhorr any further enlargements of central power, especially not democratic legitimated one.
    And what about the financial system? How can it be saved without Quantitative Easing and central power?
    Look, it cannot. If we try to, we enter an even more corrupt, more injust system. The banks are practically nationalized – why not do some honest accounting and follow up legally? Then allow new banks to be formed with new rules – high equity, low derivatives.
    Sure, this will not happen as finance and politics are too intertwined. All discussion is about how to kick the can this time.
    As Charlie Munger would say: And then what? If the ECB buys all the debt, the worse the paper the more eagerly their demand for it – what is the next step? Trash the currency into hyperinflation and/or raise tax rates further?
    You think some Europeans will work and continue to follow the rules while others milk them and sit at the beach ? How shall this work for longer then a few years?
    Once one state shows the guts to leave this Common Lunacy, what exactly will Brussels do? Send troups into Netherlands or Austria ? What happens Germans pay their taxes like Greeks ? Who will march in and tell them otherwise? Do not kid yourself: The path Munchau advises leads to a central police and military force. Europe is peaceful now and would stay that way for at least two generations (for historic and demographic reasons) – how can anybody whish for a Central Authority with an army ? Look what the US has become…..

    Centerum censeo: The Financial Sector has to be cut back drastically whereas the backbone of civilization has to be secured on the subsidiary, local level.

    1. NOTaREALmerican

      Re: Look what the US has become…..

      Good comments.

      Unfortunately, for the US, the peasants are now all either big-government socialists or fascists; and – of course – the nobility benefit regardless.

      The psychopaths have won.

    2. Swedish Lex

      Hubert,
      A question.
      How much do the large German banks and the Regional Banks still sit on large holdings in German manufacturing? I know that this elaborate system of cross holdings (Deutschland AG) has been wound down considerably over the past decade, but if the insolvent German banks are nationalised, it would mean that the German government would become a significant owner of German industry.

      For the State to own banks + having stakes (including some control positions perhaps) in large German Industry groups would not go down well with Herr und Frau Schmidt, I suspect…

      1. Hubert

        SL,
        not an issue now. And would not have been big even ten years ago as the Landesbanks never owned a big piece of industrial Germany.
        Most industrial holdings were with the private banks and insurers which then mutually owned each other (Deutsche, Dresdner, Commerz, BV, Hypo, Allianz AMB) . It was the typical structure to hide a lack of capital (“wechselseitige Beteiligungen”) and quite common in other countries too (South Africa f.e.).
        But Deutschland AG got sorted out somewhat in the last 20 years by M&A and setting scent marks.
        One could make an issue out of it if one disregards the labels “debt” and “equity” and just look straight at what an unsecured industrial loan constitutes: low yielding senior equity, I would argue.
        As many German companies do not have equity ratios above 30%, one could argue that loans to these companies have some equity-smell to it.
        And once the crisis will have thrown the second monkey wrench into the German export machinery …. But we may be getting too far ahead here …
        Anyway, things happen on a case-to-case basis: Opel is one not very encouraging example. The commonality factor will be jobs saved by politicians. The more jobs involved the more politics when restructuring a large company with job & credit guarantees and equity injections.

        1. Swedish Lex

          Hubert,

          Your analysis seems reasonable.

          A bit of shares together with big chunks of debt, and we are beginning to talk of creeping corporate control. If a handful of financial institutions were to come (formally) under State tutelage, then the Government could potentially see a “strategic national value” to pool those stakes. Another powerful tool would be added to the tool box (depends on who is in power – the current coalition looks a bit shaky). A fair amount of speculation, I grant you that, but not an unlikely scenario if things keep moving in the same direction as they currently are.

          Interestingly, there could be parallels in France.

  3. Paul Repstock

    Wow! Yep, that is the meat that should have been in the sandwich.
    I note an odd situation though: The people can nolonger vote with their feet. But, the market always votes with their money. This liquidity crisis is not news, and the stress tests have been aired for some time. But, the markets are not crashing and the currencies are holding up if not rebounding against the reserve???

    Ergo; either the common people are thrilled with the King’s bare ass, or there is something else out there which is either a greater percieved threat or else a stabilizing influence.

    Perhaps the Cosmic Drift is in control. Call it luck, call it fate. There appears to be an over riding force which supercedes everything else. Planners, plan. Bankers, bank. And manipulators, manipulate. But, in the end, The best analysts are not much more usefull than ‘warm smoke blowers’.

  4. danny

    The strees tests are a PR exercise to make it appear that euro wide bank taxes are required alongsode a resolution fund coupled with other tyranical measures. Why do people not realise that the mainstream press is doing the bidding of the financial/political elite of the world?

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