Post stress tests: lending conditions likely to remain tough

July 26, 2010

SnipImage-Jane Foley is research director at The opinions expressed are her own.-

The financial markets have been pre-occupied with all aspects of the EU bank stress tests over the past few weeks.
For the man on the street, however, the debate boils down to just one question: when will credit become cheaper and more readily available?

The Bank of England recently reported that the stock of lending to business contracted by £2.3 billion in May.  Data from major UK lenders has indicated that net lending remained weak in June.

The lack of new credit is frequently blamed for stifling the pace of economic recovery.

Yet the banks cannot be held completely accountable for this.  One key legacy of the financial crisis was that bankers had to become more prudent when evaluating risk.

Not only that but banks currently face relatively high costs of raising longer-term funding.  This factor goes a long way to explaining why lending rates appear to be so much higher than the Bank of England interest rate.

The chart above  show the heightened price of a five year credit default swap on European banks (a CDS is an insurance policy in case the issuer were to default on its debt).  The surge in the price of the CDS this year reflects the view that bank debt has become a far more risky investment.

As investors demand a higher risk premium from the banks, it follows that it becomes more expensive for the banks to raise funding.

In addition to potential questions regarding the amount of problem loans that banks may themselves be holding, in Europe in particular the ability of banks to fund themselves in the open market has been impacted by concerns about the amount of sovereign debt on their books.

This factor has made the sovereign debt crisis in Europe inseparable from concerns over the banking sector.   This year the market has re-evaluated the default risk on various sovereign bonds.

It follows that the banks suspected to holding large quantities of the paper of less solvent countries would have their solvency questioned too.

It was the confusion and lack of transparency over the relative strength of various banks that led to the demand for the publication of stress tests on banks.

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