Euro Bank Stress Tests Hoist on PR Petard

We’ve been critics of bank “stress tests” from the get-go, because they were a shameless misuse of regulatory credibility as a tool to prop up bank stock and bond prices. It was in some was the inevitable result of how badly financial authorities (save some lonely but prominent figures in the UK, like Mervyn King and Adair Turner) have been coopted. They honestly seem incapable of imagining a banking industry very different from the one we have now, much the less moving towards one.

The reason the US one was so successful was that the incoming Obama Administration, which was still in its honeymoon phase, threw its full authority behind it. The marketing efforts were intense; the Wall Street Journal, for instance, had front page stories virtually every day with various leaks of how the process was going.

The scathing comments of well informed critics, like former bank regulator Bill Black, never got aired in the MSM, even though journalists could not have been ignorant of his views (Black has told me that after a full hour PBS interview that took place midway through the process, in which he declared that there were no real stress tests going on, he was not contacted by a single journalist. And it wasn’t as if they were providing dissenting views via other sources).

Even though this blog and quite a few other commentators dismissed the stress tests as mere window dressing, they did have at least require banks that came up short to raise equity, and if not in the markets, via being force fed by Uncle Sam. The boosterism worked, and lots of banks sold stock quickly enough on the bank rally (also goosed by phony accounting, which was derided by Meredith Whitney but hailed by Mr. Market) to make the entire exercise look to be a rousing success. Of course, some wee problems went uncommented on. For instance, the Treasury insistence that the banks were in rude health meant that all the back door subsidies meant to rebuild bank balance sheets on the sly, the biggest being super low interest rates, led to strong earnings that were not retained, but walked out the front door in the form of record 2009 bonuses.

The European version of the stress tests was a cynical, lame copy of the US version. The Treasury effort at least had the appearance of rigor and enough media hooplah and bank grumbling to fool a lot of people. The Eurotests were done far too quickly, and perhaps more important, it was patently obvious the results were pre-ordained.

Our favorite commentary, which illustartes why you can’t have meaningful tests when no one is premitted to fail, comes via Saturday Night Live:

So now the Wall Street Journal gives us an update on the predictable outcome. Having started out with a dubious brand proposition, the sham version of a test, and having made abundantly clear in the half-assed Euromarket version what a canard it was. Not only did it assume far unrealistically low haircuts on bank sovereign debt exposures, but a mere six months later, two big Irish banks absurdly given a clean bill of health are now on the ropes.

The Euroauthorities have a new iteration of the exam due to be performed in early 2011. But now the contradiction of aims, meaningful assessment versus con game, is now in the open. And so the various national banking authorities are squabbling: do they have the results be public, as before, which will assure a pass/pass grading system? Or, mirable dictu, do they take the evaluation seriously this time, which means results must be kept secret? Oh, but that means Mr. Market will not be happy!

Key excerpts from the Journal story:

European officials are planning a new round of bank “stress tests” designed to be more rigorous than last summer’s widely criticized exams, but the effort is already beset by squabbling and the possibility that the test results won’t become public….

On Tuesday, a European Union official for the first time publicly acknowledged problems with last summer’s tests. “There was some variety in terms of rigor and application of these tests,” European Economic and Monetary Affairs Commissioner Olli Rehn said in Brussels…

Liquidity, which banks use to finance their daily operations, recently has emerged as the Achilles’ heel for a number of European lenders. Banks perceived as risky are seeing jittery customers pull out their deposits, and risk-averse investors are shunning such banks in the bond markets. Such liquidity squeezes can topple even relatively healthy banks or require taxpayer bailouts.

Yves here. Notice how no one is prepared to admit that solvency is the real problem? And the political wrangling is not trivial:

EU lawmakers in Brussels last summer signed off on the creation of three pan-European regulatory authorities, including the EBA, to replace the existing committees of national supervisors across the continent. Those committees have been relatively weak because they lack specific powers and are often hobbled by squabbling among their members.

The EBA, by contrast, will be authorized to craft binding rules that will apply across the EU. It also will have the power to mediate disputes between regulators in different countries.

Even before it gets off the ground, the EBA is encountering turbulence. Its launch, originally planned for Jan. 1, is being pushed back by at least a few months. It only recently posted advertisements seeking a new chairman and executive director, and hiring of other top officials is on hold until those positions are filled.

Complicating the process, the EBA is allowed only to hire employees who speak at least two European languages, one of which must be English.

Kay Swinburne, a U.K. member of the European Parliament, said she is “furious” about the bilingual requirement, which she fears will disqualify some U.K. regulatory officials. “Most expertise comes from London,” where many speakers aren’t fluent in a second language, she said. “Even just a simple thing like a language requirement limits the pool” of possible staff….

More worrisome to other experts is that the EBA’s structure will remain vulnerable to squabbling among countries. For example, the design of the next round of stress tests will be subject to a majority vote among EU members. Other issues, including the writing of rules and standards, will have to garner a two-thirds vote. That could prove to be a hurdle on controversial issues.

This process looks likely to make for good theater and bad outcomes.

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14 comments

  1. Carter the Examiner

    Yves,

    You can continue with this meme that the stress tests were “a shameless misuse of regulatory credibility as a tool to prop up bank stock and bond prices” but you are wrong (commenting only about the US process). Your readers should read what the GAO (no fan of the bank regulators) had to say: “SCAP largely met its goals of increasing the level and quality of capital held by the 19 largest U.S. BHCs and, more broadly, strengthening market confidence in the banking system” – http://www.gao.gov/new.items/d10861.pdf

    And it wasn’t “leaks” and “marketing efforts” that made the program successful, but instead 1) credible loss estimates combined with 2) the Treasury’s Capital Purchase Plan backstop.

    1. Philip Pilkington

      @Carter

      I think that those measures that you list as ‘successful’ are precisely the measures that Ms. Smith is referring to as a ‘PR stunt’.

      I think she considers them so, because they are a sort of last-minute, fast-forward regulation that doesn’t guarantee any lasting regulatory measures in the long-run. In that sense, you could refer to them as a PR campaign.

      I’d tend to agree with Smith on this one, mind you.

      1. Carter the Examiner

        Fair point. But my point (and I was there) is that the stress tests were not some sort of sham, and the insinuation is grating. Quite a bit of diligent effort by many very talented folks went into the stress test, and overall the market found them credible.

        Many banks had become uninvestable. Investors could not estimate the capital needs of the firm, the likelihood that the funds could be raised, or the supervisory response. The stress tests in the US 1) provided an informed estimate of capital needs based on superior private information, 2) provided a backstop if firms were unable to privately raise the needed capital, and 3) at least implicitly gave the market a bogey for a supervisory reaction function.

        Banks needed to be kept adequately capitalized so that a deleveraging cycle would not commence, worsening economic performance through even less credit availability.

        But bottom line, I’m tired of the insinuations against folks who work hard and do the job for the right reasons. Thanks for letting me vent.

        1. Fractal

          Most Americans are not “insinuating” anything against examiners. Most Americans just don’t believe a single word the banks say because the banks are widely engaged in criminal conduct. As the British govt officials have had the balls to say, and only a few journalists in the US have recently said (e.g., New Yorker article last month), the large money-center banks serve no social purpose. As corporations, they have abdicated the social purpose of their corporate charters. The large TARP banks (former TARP recipients) are worthless to the U.S. economy. The money-center banks work only for themselves and do nothing to promote the national economic welfare. We believe the bonuses paid to the millionaire traders are criminal theft directly from the U.S. Treasury. We don’t care if the banks paying billions of dollars in those bonuses are all “resolved” into non-existence. We are eager to see all of their top executives and directors in prison.

          Thanks for letting ME vent.

        2. Anonymous Jones

          I apologize if this appears rude, but I do not believe you. It’s not that I question your integrity or your hard work, but I do not believe you investigated in the right places nor do I believe you started with the correct assumptions.

          I’m also in the game, understand the losses the banks are taking and are *going* to take, and have a fairly good insider’s take on the gearing that exists within the banks. The rough numbers don’t seem close to adding up; so I hope you understand where my skepticism comes from. I don’t *know* how bad a shape the banks are in, but I would be highly surprised if it was outside of some reasonable range. What you are telling me is that they are *far* outside that range.

          I’m sorry, but there are three crucial problems with your assertions. First, the actual accounting of most of these banks is too complicated and too opaque to have been digested in the amount of time claimed to have been used for the stress tests. Second, it is not plausible that the raw data you received from the banks was tested thoroughly enough to feel comfortable with such data (trust me, I’ve done forensic accounting and sometimes the bogey in the cooked books is *very* hard to spot). And third, the assumptions taken in the stress tests have been debunked over and over again.

          Yes, many people work hard and are extremely talented. Look at the Minnesota Timberwolves. They have extremely talented players (some of the best on earth) and work tirelessly. They still lose 75% of their games. Failure happens. Your effort and your talent will not always prevent that.

        3. attempter

          “Talented”! I thought we’d seen the end of hacks unironically using that term.

          I have no doubt at all you and your fellow criminals consider yourselves talented at your crimes, but you’re really no good even at that.

          That’s why you’re still telling the same lies. But we all know the banks are purely criminal enterprises which produce nothing and should have perished.

  2. Sergei

    Many european banks may indeed be insolvent, if they have to take haircuts on sovereign and counterparty exposures, or write off real estate exposures. Nevertheless, insolvency usually do not lead to a rapid demise of a financial institution, and it is indeed liquidity that can topple a bank overnight… Witness Bears and Lehman. If you look at the Japan in the 90’s, the country was filled with insolvent banks, but these zombie banks could keep on operating due to ample liquidity in the financial system…

  3. Sergei

    and these zombie banks eventually rebuilt their capital through years of retained earnings, as did their borrowers…

    1. ScottS

      Sergei,

      You’re correct that Japanese banks have more or less rebuilt their balance sheets, but at what cost? Decades of growth and innovation evaporated, deflation, and a possibly fatal malaise.

      The Japanese social contract has broken down. There is no more lifetime employment. Young people don’t hold jobs longer than a few months (called “free-timers”). The population is shrinking at a frightening pace. Wealth is diverging, which tears up the crucial myth of Japanese homogeneity (they share the same ancestry, come from the same socio-economic background, have the same outlook, etc). Saving is penalized by deflation. Ask any Japanese person what they think of Americans, and they will describe us as optimists. The idea that we look like optimists to anyone tells you a lot about their outlook.

      Seriously, all that to avoid biting the bullet and giving the wealthy bank backers a haircut. That’s what America, and the entire West, is looking at. Not a good deal, if you ask me.

  4. Sergei

    What I meant to say is, if you are insolvent, but stays liquid, you can rebuild your capital over time given the chance. But if you are solvent, but illiquid, you are toast.

    1. John Kissinger

      If you are illiquid a sovereign can easily loan funds sufficient to stop essentially any bank run. For example, FDIC insurance has prevented all bank runs since the thirties; for those institutions that were insolvent in addition to being illiquid it was able to wind up or merge thousands of banks without any run on deposits.

      If you are insolvent you are bankrupt unless and until a) taxpayers make you solvent, or provide sufficient liquidity at low interest, and/or you manage to acquire new funding from a gullible market. All of these solutions are a poor allocation of capital that harms the economy, e.g. for decades in Japan, made substantially worse if the illusion of health leads to higher salaries and/or bonuses, which makes the problem of curing the insolvency that much worse.

  5. Fractal

    slightly OT, but for today’s version of “good theater and bad outcomes,” or for “PR stunts,” please listen to at least part of the Senate Banking hearing on foreclosure fraud:

    http://www.c-span.org/Watch/Media/2010/12/01/HP/R/41332/federal+Officials+Pressed+on+Mortgage+foreclosure+Crisis.aspx

    Yves favorite lying lobby group, the ASF, marched up and boldly claimed that it is a myth that the mortgage notes for the trillions of dollars of mortgages in securitization trusts were not properly assigned to the trusts. Nobody even bothered to question the ASF witness about such bullshit testimony, at least not as of 30 minutes after the ASF’s opening statement.

    Remarkable moment occurred when Fannie Mae witness admitted Fannie & Freddy are NOT ALLOWED TO TALK TO SOME OTHER PARTIES PURSUING FORECLOSURES, except through their regulator, the FHFA. FNMA witness claimed “antitrust” rules prohibited such direct exchanges. Dodd was flabbergasted and tried to provoke a direct exchange right at the witness table.

  6. karen1p

    Yves,
    This is a little “off topic” but I never know where to post these kinds of things.

    Genuinely, I ignore what I see as egregious conflicts of interest….but cannot ignore today. On your advertising header today is an ad for ALLY BANK! You must know that Ally Bank was the first bank to be popped for the robo-signer scandal.

    As a homeowner going through this mess, I appreciate your blog and all that you do to make the public aware of these criminal activities, but at the same time, I really have a hard time that the advertising is also giving these criminals access to your readers.

    What gives?

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