European Stress Tests – could do better
The European bank stress tests had something for everyone. Optimists will focus on the reams of information provided on the 91 banks tested. Pessimists will focus on the fact that assumptions were not stringent in terms of sovereign debt exposure, or the definition of tier 1 capital. By country, Spain appears to have benefitted the most, but doubts over the German banking system linger and even in Spain recapitalisations may need to be larger than so far envisaged.
On balance, the stress tests are an important step forward, supporting risk sentiment in the short term, but they are not the panacea some had hoped for. In particular, we think the need for recapitalisation has been underestimated and, as a result, a restricted credit channel will act as a drag on euro-zone growth in the medium-term.
Stress tests – methodology & results
The Committee of European Banking Supervisors (CEBS), in coordination with 20 national supervisory authorities, conducted the stress tests on a sample of 91 European banks, representing 65% of the European market in terms of total assets. The tests involved two scenarios: a baseline or benchmark case, and an adverse scenario that includes a global macro-economic shock as well as an EU-specific shock to government debt.
The benchmark macro-economic scenario assumes a mild recovery from the severe downturn of 2008- 2009, whereas the adverse scenario assumes a "double-dip" recession where cumulative GDP over 2010-11 is close to three percentage points lower than the benchmark scenario.
Critics have pointed out that the sovereign shock does not assume a restructuring or default. As a result, banks do not have to mark down government bonds held in their banking book - only sovereign exposures in their trading book take a hit.
In the adverse scenario, 7 European banks would see their tier 1 capital ratios fall below the 6% minimum limit identified by the CEBS. Together these banks are identified as needing to raise an extra €3.5 bn in capital.
Positives
The biggest positive from the stress tests was the accompanying release of a substantial amount of information on the exposures/assets of the 91 European banks. This allows analysts to conduct their own stress tests over the next few days and weeks and reduces ‘information asymmetry’ in the financial system.
Lack of information can often make markets act inefficiently and sometimes seize up completely, as George Akerlof first noted in a 1970 paper for which he later won the Nobel prize, "The Market for Lemons: Quality Uncertainty and the Market Mechanism". He took the example of the secondhand car market, and how lack of information on the part of the buyers about the quality of the cars being sold would lead to bad cars forcing good cars out of the market. In other words, Swiss Toni’s dodgy motors could cause punters to lose faith in the whole used-car market.
Similarly, lack of information about where exposures lie, including sovereign bond exposures, was in danger of making the European interbank market seize up. Many peripheral euro-zone banks were already effectively closed out of interbank lending, and reliant on emergency funding from the ECB for their liquidity needs.
The initial market reaction has been positive. In anticipation of the stress tests, and the extra information they would provide, the cost of insuring against the default of European banks fell, as measured by Credit Default Swaps (CDS). The share prices of many European banks have also reacted favourably following the tests.
Negatives
However, there were a number of areas where the stress tests left room for improvement, particularly in terms of assumptions and recapitalisation plans.
1) Assumptions
The macroeconomic assumptions about growth, unemployment and falls in residential and commercial property prices appear aggressive, but there are a number of areas where the assumptions of the stress tests were not as stringent as they could have been.
In particular, as noted earlier, the sovereign stress test scenario excluded banks exposures outside of their trading book. In addition, the stress tests use a generous definition of tier 1 capital that includes hybrid debt.
Perhaps the most worrying assumption is that banks are allowed to run their credit-loss reserves to zero in order to meet the 6% tier 1 capital ratio limit set by the CEBS.
This appears overly generous to us, and effectively understates the need for recapitalisation in an adverse scenario. It is unlikely that the market would look favourably on a bank with a 6% tier 1 capital ratio, but no provisions against further losses. Most private estimates of the need for recapitalisation of the Spanish banking system, for example, have ranged from an extra €20-50bn.
2) Recapitalisations plans
Indeed, recapitalisation plans announced in the wake of the stress tests have been modest compared to recapitalisation of US banks after their stress tests last year. In total, the European stress tests identified a need to raise an additional €3.5 bn in additional capital, compared to the $75 bn raised after the US stress tests. It is encouraging that some of the weaker European banks, which only just met the 6% criteria, are also raising additional capital. But overall amounts are still small.
Conclusions
If, as we suspect some European banks are still in need of an additional capital cushion, this has important implications for economic growth in the medium-term. Some banks will be reluctant to lend, suggesting the credit channel in the euro-zone will remain impaired and act as a drag on growth. This supports our forecast for weak growth and low inflation in 2011, despite the current cyclical recovery.
Finally, by country, Spain appears to have benefitted the most from the tests. They have acted as a catalyst for reform of its troubled ‘cajas’ and the information released on individual bank exposures is substantial. This has also helped reduce market concerns about the exposure of the Spanish government to its banking sector, with CDS on Spanish government debt falling back and the spread between Spanish and German government bond yields narrowing. In contrast, doubts over the German banking system linger.
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