The big problem with Europe’s stress tests

July 15, 2010

Can Europe’s bank stress tests do for banks over there what the US tests did on this side of the pond? Mohamed El-Erian is not optimistic:

Last year’s stress test in the US applied to institutions that were the main cause of the financial instabilities, and the government had budgetary room to support the sector. Europe’s situation is different. The concern about banks is a derived concern, reflecting worries about sovereign debt in some countries and the overall economic situation; and there are greater limits today on budgetary resources.

In other words, if bank solvency is the problem, then the government rescuing the banks — or forcing them to recapitalize — can be the solution. But if government finances are the problem, then it’s very unlikely that any kind of intervention in the banking sector can solve anything much. The one thing which no one was worried about during the financial crisis of 2008 was US banks’ exposure to the US government. But the one thing that everybody is worried about in 2010 is European banks’ exposure to European governments.

That said, I think and hope that the European stress tests, if they prove credible (and that’s a big if), will get the interbank market moving again at least between the strongest institutions. Which would be an undeniable improvement on where we’re at now. As El-Erian explains:

Europe would be in the midst of a major banking crisis if the European Central Bank had not become the major counterparty to both sides of the interbank market. Weak banks go to the ECB for liquidity. Strong banks deposit their excess funds at the ECB rather than face other banks in the interbank market.

And what’s to become of the weak banks? Well, they either recapitalize or get taken over by strong banks. Europe’s banks are too big already, and they’re about to get bigger, it seems. But that always happens in a crisis. When you’re worried about solvency, concerns over size always retreat to the back burner.

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