Stress tests for European banks completed

Stock markets started collapsing at the beginning of May after investors suddenly started paying attention to the debt crisis that was plaguing European banks.  Specifically those rascally Greeks sent folks into fear paroxysms.  As a part of calming investor stomachs the Europeans stated that they would undertake “stress testing” of the European banking system.  The goal was transparency for the financial markets.  Investors were assuming apocalypse because they didn’t know what really was happening at the individual bank level.

The results of the European stress testing were announced today.  Here is a summary of the major findings.

• Of 91 banks scrutinized, only 7 would need to raise additional capital (i.e. equity) in the event of a further recession or in the event of a government bond default.

Analysis: In case you are not schooled in the rigors and obscurities of bank financing let me briefly explain what all of this means.  Banks are not required to keep on hand all of the cash that they receive as deposits.  Instead they are allowed to lend out or invest huge portions of that cash.  But they are required to leave some cash, reserves, on hand in the event that some of their investments don’t perform as expected.  This is similar to the equity:debt relationship of a home.  Homeowners are not usually required to plunk down the full purchase price of a house.  Instead they put down a portion of the worth of the house as equity while banks finance the rest with mortgage financing.  That equity is supposed to protect the banking lender in the event of a decline in the value of the house or a default on the part of the homeowner.  Well the same is true for banks and their cash reserves.  So these stress tests are trying to answer the question of how much of those reserves (equity) would be wiped out in the event of a decline in the value of the banks investments (including mortgages, investments in bonds, etc.), most likely due to an economic decline.  Does this make sense?

So that only 7 of the 91 major banks in Europe would be in trouble in the event of a big decline in the economy is a good thing.  This result is much better than expected.  Which brings us to the next piece of disclosure by the Europeans today…

• Those 7 banks that failed the stress test would need to raise 3.5 billion euros in order to get capital up to safe and strong levels.

Analysis: That 3.5 billion euro figure is significantly lower than what had been feared.  Investors had been throwing around numbers ranging from 30 billion euro up to 90 billion euro (!).  How could the analysts have been so wrong?  Well, not coincidentally, that brings me to my next point…

• What exactly were the criteria of the stress tests?  No one publicly knows precisely what criteria were used.  Some of the criteria are slowly making their way into the media.  To me the criteria look a little flimsy.  For example, the stress tests largely focused on the damage an economic decline or debt crisis would have on the short-term investments of banks.  That is, the long-term investments (those with maturities over 5 years, I am guessing) were not considered.

Analysis: Clearly this is bogus.  A bank’s financial strength can’t just be evaluated based on the performance of their short-term investments.  The economic shock-factors that were modeled – a declining economy and debt crises – wouldn’t exclusively affect short-term investments.  Those are big, macro shocks that would affect all investments.  Are the Europeans mad?

Which brings me to my next point…

• Why would the Europeans go through this process of reassurance, only to emasculate its potency?

Analysis: The Europeans are proving yet again that politics trumps economics.  There is the whiff of a compromise in these stress tests.  If the tests were overly strident the results might have triggered panic and they would have been the very seeds of destruction that the tests were meant to alleviate.  But if the tests were too namby-pamby then they wouldn’t have credibility.  I feel what we have here is something in-between.  Unfortunately, these tests are not going to completely erase fears that the European banks are teetering on the edge.  I feel that the Europeans have missed an opportunity here to quell fears, increase transparency, and for themselves, to actually process reality, not financial fantasy.

I don’t want to be overly harsh.  The stress tests are net, a good thing.  Let’s hope that the tests allow some breathing room for stressed European banks and an increase of confidence on the part of investors.

Importance grade: 10; this was one of the most important pieces of economic news in the last 3-4 months.  Unfortunately, the impact has been diluted because of the questions surrounding the stress test criteria.

Jason