Not much stress, not much test

July 26, 2010

-Laurence Copeland is professor of finance at Cardiff University Business School. The opinions expressed are his own.-

Back in the 1950’s, when most women stayed at home while their menfolk went out to work, a favourite trick of life insurance salesmen was to walk into the prospect’s home at dinner time and ask the wife:

“Mrs Smith, have you ever thought what would happen if your husband keeled over and had a heart attack right now?”

Imagine the effect of this question on the poor guy sitting there eating his meat and two veg. It must often have been enough to make him choke on his roast potato there and then – maybe even die on the spot.

Not being in the business of selling life insurance, the European bank regulators were unwilling to take any chances with the client’s cardio-vascular system, so they have restricted themselves to asking the question:

“What would happen if the client had the flu and needed a couple of weeks off work?”

Specifically, the stress tests were restricted to three possible scenarios: continuing recovery, a second recession (but nowhere near as severe as in 2008-9), and a rerun of something like the Greek crisis earlier this year superimposed on a recession.

In this third scenario, sovereign debt was assumed to fall in value by 25 percent – at least for problem countries.

In one respect, this is inconsistent.

After all, government debt only trades below face value because markets see a danger of default. Where there is no risk of default, there is no reason why I should be unwilling to pay the present value of 100 pounds for a promise to deliver 100 pounds in the future.

To relate this statement of the obvious to the current context, what spooked the markets during the Greek crisis was the prospect of default – in fact, of a double domino effect, as sovereign defaults cascaded from one Mediterranean country to another, putting unbearable pressure on the lenders, who are overwhelmingly the giant European banks based in Germany, France and to a lesser extent UK and Switzerland.

You can see why the people from the Committee of European Banking Supervisors (CEBS) decided not to bother with this scenario at all, because we already know how it ends up: we go back to more or less where we were in those dark post-Lehman days of September 2008 – only far worse, because we’re starting from a weaker position and because European crisis resolution is bound to be slower than American.

We also know that Europe would emerge from a crisis of that type with some form of nationalised or semi-nationalised banking system, as we already have today in the UK, with taxpayers again picking up the bill – and with the prospect of years or even decades of misery ahead of us, as we work to recapitalise the banks and pay off our debts.

Even ignoring sovereign risk, you could well ask the question: what does it mean to say Big Bank A would survive in a given scenario, whereas Big Bank B would not?

Clearly, any bank which is Too Big To Fail is ipso facto a threat to all the other banks, so if it fails in any particular scenario, so do all the others. At this point, those with an academic inclination might like to distinguish between insolvency and illiquidity, but the distinction is entirely lost on depositors and share holders, so it is truly academic.

So the stress tests essentially ask whether the banks can withstand the normal buffeting that they face in non-crisis times – like the decades before the credit crunch in mid-2007, which now seems like a far-off golden age. You may well ask what is the point of the whole exercise – a question which must have kept popping up in the minds of the folk burning the midnight oil at CEBS in the last few weeks.

After all, the ratios computed by CEBS will be out of date as soon as trading starts on Monday, but who cares? As soon as the idea of stress tests surfaced, a refusal to go ahead would inevitably have been interpreted as a sign that regulators were frightened of what they would find. So one answer to the question is that, like climbing Everest, stress testing had to be done because it was there to be done.

Those who manage the savings of the masses feel insecure and unloved – almost as if they don’t deserve the billions they are paid (perish the thought!). In this box-ticking age, their ample rear-ends could be exposed to a good kicking without the protection of a thick wad of paperwork – in the form of a report which can be used in their defence if in the future anyone has the temerity to question their judgment.

It is in other words a document to sit on the bookshelf in the offices of pension fund sponsors in Europe, U.S. and Japan. It needs to be translated into Arabic and Chinese for the sovereign wealth managers in the Gulf and the Far East. These are the people we are relying on to carry us through the process of rebuilding our banking system in the coming decade.

For taxpayers, however, there is little comfort. The stress tests tell us it might cost 3.5 billion euros to rebuild so-called Tier 1 capital up to the required 6 percent level at each of the seven banks which failed the tests.

Multiply that figure by a hundred, and that’s a starting point for estimating how much it is going to cost us to clear up the mess if, or when, the balloon goes up. More realistically, multiply by a thousand.

How will the markets react on Monday morning?

Like me, I suspect they were worried beforehand, but did not expect very much reassurance from the stress tests. I guess they’ll decide they’ve got more or less what they expected – not very much. If you’ll pardon the U.S. Army slang, it’s a Normal Situation – a SNAFU, in fact.

Picture Credit: Traders watch as the results of the European banks stress tests are announced on the floor of the New York Stock Exchange July 23, 2010. REUTERS/Brendan McDermid

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