The silver lining to the lenient stress test

By Felix Salmon
July 23, 2010
nothing in the way of bad news coming out of the European bank stress tests. Essentially, the tests could be tough or they could be lenient; and there could be significant failures or no significant failures. The outcome, in the end, was that the tests were lenient and that there were no significant failures.

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There’s a certain amount of relief in the markets that there’s absolutely nothing in the way of bad news coming out of the European bank stress tests. Essentially, the tests could be tough or they could be lenient; and there could be significant failures or no significant failures. The outcome, in the end, was that the tests were lenient and that there were no significant failures.

Clearly, a tough test with no significant failures would have been better news — but at the same time, a lenient test with significant failures would have been worse news. So we’re somewhere in the middle, and muddling along: in the CDS market, most banks have seen their spreads tighten modestly, by single-digit amounts, according to Markit.

The European stress tests are less credible than the US stress tests, for reasons laid out by Chris Whalen and many others. They’re a bit of a europudding, but they’re better than nothing. And it’s worth remembering that a lot of people had similar reactions to the US stress tests, too, immediately before and immediately after they came out — few people at the time reckoned that they would have much effect in terms of restoring confidence and credibility to the interbank market.

But they did help, a lot, mainly because they forced US banks to raise a lot of new capital. The European stress tests don’t do that, and therefore they look like a bit of a waste of time. Remember that the markets, like the rest of us, prefer to see actions to words, and the actions which followed the US stress tests undoubtedly strengthened the US banking system. By contrast, the European stress tests don’t seem to require any extra capital-raising whatsoever from any banks that anybody cares about. Only seven banks failed; three are state-owned already (Germany’s Hypo, Spain’s Cajasur, and Greece’s ATEBank), and the other four are tiny Spanish banks you’ve never heard of.

In any case, the only stress test that global markets really care about, in the European context, is a Greek default. And this stress test didn’t even attempt to model what might happen to European banks’ balance sheets in that event.

Was there any point in doing this test? I think so, yes. It got all the European national bank regulators talking to each other and cooperating more than they do normally, and thinking hard about important questions related to the solvency of the European banking system. The test itself was weak, to be sure. But the Committee of European Banking Supervisors has a lot of granular information now which it can try to use for the purposes of crisis prevention. Whether it will or not is unclear, as is whether it will succeed if it tries. But its very existence is probably a good thing. So even if the stress tests look like a joke, they might have something in the way of positive consequences.

11 comments

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They were supposed to test this simple equation:

investment = investment + profit

gambling = gaining or losing

People are deceiving on investment and getting losses on the principal.

Governments are helping banks to deceive regular citizens on what is supposed to be investment and retrieving their money back with something else.

This worldwide economic meltdown is just a failure of advanced countries trying to make money beyond production capability.

The poor souls are letting combined greed and fears mar simple functioning of offer demand.

The economy can work pretty well when honesty is played in the front line.

Posted by Hydrology | Report as abusive

C’mon Felix. You’re letting the Eurocrats off far too lightly. Mr. Whalen’s objections to the whole exercise were well-argued, and his essential point that there should be one regulator with one common accounting standard for ALL the banks in the Eurozone still stands. Was there any movement, even in the slightest, toward a pan-Eurozone bank regulator? None that I can see.

Posted by Gotthardbahn | Report as abusive

Silver lining….or a requirement for silver bullets?

It’s unlike Mr Salmon to go along with this kind of sloppy and fraudulent spin.
1. The treatment of sovereign debt at book trading value is laughable – it’s a much bigger liability than that.
2. 91 banks in total – when 170 the week before last quoted difficulty in getting at wholesale monies.
3. The release made at 5.01pm GMT – when most euromarkets had closed.

There is NO WAY the European banking fraternity is in anything less than 20 feet of doo-dooh. This was a poorly executed and secretive snowjob from start to finish.

http://nbyslog.blogspot.com/2010/07/brea kingdismay-as-eurobank-stress-test.html

Posted by nbywardslog | Report as abusive

I think the silver lining has a lot of burgeoning black clouds behind it.

There is never much positive about a whitewash as it comes off even in a light rainfall.

Posted by hsvkitty | Report as abusive

Coming from a developing country like Brazil today I am aware that my country is not strong, but the developed country are falling to their knees for an ‘advanced economy’ prone to fail because the stock exchange became a huge rot system even worse than gambling.

When you lose your money in Las Vegas the casino owner gets it diverting to some other use, at least your currency stay alive in the economy. But, when you lose your money at a Stock Exchange System nobody gets your lost money meaning that it vanished in the same way that some could be created. The economic meltdown of 2009 vanished with around 40 trillion dollars that no government can mend with rescue packages. In general people are naïve as brokers always make money preying of greed and shallow souls.

The truth is that those wise guys in the developed country are smart to spoil the worldwide economy, get obese because of concentration of resources putting together excessive food and machinery to drive sedentarism to annihilate healthy lifestyles.

There one outstanding irony to think that common citizens are not reading between the lines.

The guys behind the media has no interest to show the underlying truth because their business is just to make money.

Posted by Hydrology | Report as abusive

looks like a tin lining to me. taking a glimpse at the test scenarios and assumptions would probably answer most questions one might have about the results. Perceptions and sentiment can certainly change the technicals but hardly the fundamentals. The positive consequence (for the banks) is that if they decide to raise more capital now, they would probably get a very good price. Cheers!

Posted by Tseko | Report as abusive

What worries me is not who failed, but whether any of those that passed will now reduce their capital so they move closer to that 6% limit the Eurotest required them to beat. Whether or not this level is a sufficient test of strength, it might have been useful to group banks into a series of grades, say five grades from A to E measured by how strict a test they could pass.

Posted by FifthDecade | Report as abusive

It does in fact only show that there is no clear and present danger. It doesnot show European banks are safe.
But reading between the lines it probably gives more useful info than the tests itself. It becomes more clear where the weak links are. Combining with other info and market data like CDS spreads.
Restoring interbank financing for them looks elusive, seen the CDS spreads.
Just look how many banks got into trouble 2007/08 and its fall-out. Another such event would be a real stress test. And resistance now is more essential than before as several states (especially those with banks under heavy scrutiny) are running out of money, so an European wide second bankrescue is doubtful. Opening all sorts of discussions again on contagion.
The main problem I have with the European Banksector is that hardly any real restructuring is done in the last 2-3 years. So if something like 2007/08 happens again they are very likely not able to resist it. And they are still making rather similar mistakes like too many one sided bets.
In all it looks more like not pretty successful damage-control than working towards a banksector which is strong enough to face the future and the challenges that certainly will arise.

Posted by Rikh | Report as abusive

The US stress tests did not work because they forced banks to raise more capital, most of the capital raising was announced prior to the test. The tests worked because they gave granular information about individual bank financial condition. The news was bad, but not as bad as the monster under the bed people had imagined when there was no information.

It’s silly to argue about the severity of the stress. If you want something stronger, just adjust the numbers. If the test specified a 20% fall in commercial real estate prices, and that causes a billion dollar loss in the commerical real estate holdings of an institution, it’s not hard to estimate the effect of a 30% or 40% decline. This is exactly what people did in the US stress test, because the Treasury gave them the detailed information necessary.

The Euro stress test presented only aggregate results with box-and-whisker plots, and did not go down to the balance sheet line-item level. Moreover, the results don’t pass the smell test. A stress in which asset prices fall by 20% or more and market volatility doubles only increased the risk of the banks’ balance sheets by 7.6%. That’s absurd. If you lend 80% of the purchase price of a building, and its value falls 20%, the risk of your loan went way up. If you hold assets whose volatility doubles, your risk doubles.

The problems is the test used Tier 1 capital instead of tangible common equity, and risk-weighted assets instead of mark-to-market valuations. Thus it showed only that banks would look okay to regulators in a stress, not that they had the economic resources to survive it.

Individual bank results were released by national regultors. Strong countries released detailed information about strong banks, not as detailed as the US stress tests but sufficient to show that the big multinational Euro banks will probably not fail absent a sovereign default, collapse in securitizations, funding crisis or liquidity crisis. Weak countries and weak banks avoided signficant disclosure, but most are too small to threaten sovereign credit by themselves. Spain, perhaps the most interesting country, seems to be having server problems, which is not good news. Hopefully it’s just overwhelming traffic.

Posted by ObamaDonor | Report as abusive

The only thing that the European quasi-stress tests really prove beyond a shadow of doubt is that their financial system is in such bad shape that all of their experts are certain that it would fail a real stress test.

I like hsvkitty’s observations. Well said.

Posted by breezinthru | Report as abusive

This is a test comment only.

Posted by apollo_xia | Report as abusive