News reports at the end of last week informed the financial markets that the European Banking Authority (“EBA”) failed only eight of the 90 banks examined in the most recent round of stress tests. These eight unfortunates “fell short of the required amount of capital under the tests’ simulations of a deep, two-year economic downturn,” the Wall Street Journal reports. “Those banks faced a total shortage of €2.5 billion ($3.54 billion) of capital, which banks rely on to soak up potential losses.”
Most analysts dismissed the EU stress test results out of hand because of the small number of banks identified as problematic. But investors need to understand that the stress test process in the EU, ridiculous as it may be, is only an indication of deeper problems beneath the surface regarding public disclosure and basic question of governance in the EU. Click here to read the latest report on Reuters.
The first point to be made is that the EBA banking authority does not really exist as a bank supervision agency. The EBA has no power to compel financial reporting from banks located in the 25 member nations, rendering the ability to supervise capital adequacy, much less stress testing, completely moot. The Telegraph in London ran a report today detailing the difficulty that the EBA had in obtaining information for the stress tests.
The second more important point, however, is that the culture of secrecy and a complete absence of public disclosure in the EU has doomed the process to failure. Richard Field, an expert on the mortgage sector who has been pushing for improved disclosure by the EBA and other agencies, says that EU officials are “directly contributing to financial market instability by not making the data available so that the risk of the banks they are supervising could be analyzed.”
The third point is that we do not need stress tests to understand that many of the banks of the EU are insolvent. An inspection of the data published by the International Monetary Fund suggests that many of the banking markets in the EU are badly decapitalized. Even Deutsche Bank, arguably the most important bank in Western Europe, has just €50 billion in capital supporting €1.7 trillion in total assets. Only by ignoring the sovereign and off-balance sheet footings of Deutsche and other major EU banks can anyone even for a moment pretend that these banks are solvent.
When you move from the relatively blissful climes of Germany down to Southern Europe, however, the situation becomes even more ridiculous. While many investors are still concerned by the prospect of sovereign default in Greece, Ireland or Italy, Spain arguably is the most problematic nation in the EU — and the least discussed.
The banks in Spain were run like little imitations of Countrywide Financial, the doomed US mortgage lending that was acquired by Bank of America in 2008, only with worse credit underwriting and record keeping. Indeed, to compare the largest banks in Spain to Countrywide does serious injustice to the American lender. Bad as some of the Countrywide loan production may have been, my view is that the poor credit underwriting and fraud seen in the Spanish real estate boom makes the American experience seem sublime by comparison.
The notion advanced by the EBA that any of the major Spanish banks are actually solvent is a fantasy, in my view, an opinion verified by the high levels of over-collateralization required by Spanish authorities. The excesses in the Spanish real estate sector rival the levels of idiocy seen in Ireland, but on a far larger scale. Some of the covered bonds issued by Spanish banks were so poorly underwritten that financial regulators in that country demanded as much as 80 percent over-collateralization (“OC”). This means that the bank had to pledge $1.80 in mortgages to raise $1.00 in new funding. This is more that 2x the highest level of over-collateralization required by the US Federal Home Loan Banks.
With such high levels of OC, no surprise then that Spanish banks are feeling increased liquidity pressure in the markets, pressure driven by truly hideous asset quality, not by exposure to sovereign default. But, again, there is little meaningful public disclosure by Spanish banks regarding asset quality.
Last week, I was contacted by a major insurance group in the US who wanted me to travel to their offices and give them a presentation on the state of the EU banking system. I told them to save their money, that most EU banks are insolvent and that, for the purposes of analysis, they should treat all EU banks as sovereign credits, not as private concerns — at least until the EU takes a different approach to public disclosure for banks.