Stress tests fine, now move along

Can European governments atone for their mistakes in the handling of the financial crisis and forcibly introduce genuine transparency on the accounts and risk exposure of financial institutions? With a fresh round of stress tests that have done little to restore market confidence, the European regulatory authority has tried and failed to do just that.

The figures provided by European Banking Authority do not appear to address the challenges of the current situation. Of the 90 banks tested, only eight (one Austrian, two Greek, and five Spanish) failed to comply with the stipulated criterion: a ratio of 5% of core tier one capital to risk-weighted assets. According to the EBA, these institutions, which have been ordered to present recapitalisation plans within the next three months, will need an estimated 2.5 billion euros of additional capital.

So at the height of the euro crisis and with the entire eurozone threatened by contagion, only 2.5 billion euros will be needed to recapitalise the European banking system — which is less than last year, when banks were told to rapidly raise 3.5 billion euros.

According to the EBA, the low figure has been prompted by the fact that in the run-up to latest round of tests, the banks took action to raise 60 billion euros of additional capital between January and March of this year.

EBA pledged no repeat of last year’s fiasco

But if the risk is at the stated level, how can we justify the austerity plans that are being implemented across Europe, and the introduction of measures designed to save hundreds of billions of euros? How can we explain the fear and uncertainty on financial markets, and the urgent calls from China and the United States, among others, to bring the situation under control?

According to estimates from the ratings agency Standard & Poor's, European banks will need an additional 250 billion euros, in the event of a significant increase in interest rates and a severe slowdown of the economy, while, for its part, Goldman Sachs has forecast that the banks will need €29 billion in the wake of the stress tests.

These differences in interpretation reflect the permanent lack of transparency that continues to surround the world of banking, and highlight the major weakness of the EBA tests: the fact that they have attempted to evaluate risk without taking into account the main danger to the eurozone and the world financial system in general — the possibility of the sovereign default and subsequent bankruptcy of a eurozone country.

The EBA had pledged that there would be no repeat of last year’s fiasco, when two Irish banks had to be bailed out just three weeks after passing the tests. This time around the rules were supposed to be a lot stricter. In establishing a worst case scenario – which the EBA deemed to be highly unlikely – the tests took into account two years of recession, a high level of unemployment and a depression in real estate markets.

Contagion has also reached the centre of the eurozone

As the Spanish press has pointed out, the situation in Spain is already much worse: the country’s economy has been in recession for three consecutive years, unemployment has risen above 23% and the explosion of the property bubble has resulted in a decline of more than 40% in the value of real estate assets.

At the same time, the underestimation of economic factors is only the tip of the iceberg, because the EBA has been forced to comply with the diktat of European governments and the European Central Bank, which insists that there will be no sovereign default by a eurozone state. As a result, this hypothesis and its potential impact on the banks has not been tested.

It is easy to understand why the ECB has laid down the law in this regard: traditionally sovereign bonds are considered to be low-risk securities. As such they play a dominant role in the capital of banks and insurance companies, and on a wider level in the financial system. If the risk associated with these bonds is considered to be dangerous, then the rug will be pulled from under the feet of the financial system, and the principle that underlies the creation of currency will be in jeopardy.

Unfortunately, we have reached a situation where this principle no longer corresponds to the reality faced by countries like Greece, Ireland and Portugal, whose sovereign debt is being shunned by investors. In spite of multiple austerity plans and pledges of support from Europe, yields for ten-year bills for the three countries are now hovering at levels of between 13% (for Ireland) and 16% (for Greece). Contagion has also reached the centre of the eurozone: this week, yields for Italian and Spanish bonds have exceeded 6%, which is considered to be a critical threshold for eurozone countries.

Major clean-up can no longer be postponed

Given the lack of credibility of the tests, the EBA attempted to save face by insisting that banks disclose data on their exposure. Even before the publication of the test results, the German public sector bank Helaba withdrew from the process, announcing that the rules for the evaluation of capital reserves were unfair — a criticism later re-echoed by the German banking federation, which argued that transparency would not boost market confidence.

This criticism is all the more hypocritical because while arguing that transparency is damaging, the banks have begun to adopt policies that reflect the need for more disclosure. Over the last few weeks, the interbank market has silently begun to freeze over. Banks are refusing to lend to other institutions, which they believe to be fragile. And they are not only reluctant to lend to Greek, Portuguese and Irish banks, which are now forced to seek support from the ECB and central banks, but also to certain Spanish banks, a number of German regional banks and a range of others including Belgium’s Dexia.

For its part, the European Commission has said that it is also concerned by the publication of the exposure data: "The risk that analysts will use it to establish their own stress tests on banks should not be underestimated," says a confidential European document cited by Bloomberg. "The results presented by the regulatory authority could be challenged by market testing."

This concern is justified, but it remains a consequence of the choices made by European governments. By refusing to insist that banks commit to more transparency and the cleaning of their balance sheets, which could force them to restructure or even to close, they have voluntarily placed their fate in the hands of the markets. In clinging to denial, they have armed the speculators. However, a major clean-up can no longer be postponed. On July 21 at the eurozone debt summit, European governments will have to face up to the bitter consequences of their repeated capitulation to the interests of the world of finance.

Translated from the French by Mark McGovern