Stress tests

The banking stress test results coming out on Friday are supposed to calm markets and reassure investors that banks can withstand future economic shocks. But after assurances by several government leaders that their banks will pass, economists and analysts are wondering if the tests really have much meaning and might even gloss over underlying problems.

After the close of business Friday, regulators will release detailed results of the stress tests on 91 banks, including big players like Deutsche Bank and Commerzbank in Germany, HSBC and Barclays in the UK, as well as Societe Generale and BNP Paribas in France.

But in the run-up to the release, information has leaked from several European capitals that their banks have passed the stress tests, meaning in all likelihood, far fewer banks than expected will have failed. While it sounds like good news, analysts say the whole exercise risks backfiring.

"People in Europe did not want a lot of banks to fail to create a panic, but I have the feeling that the tests have not been made as rigorous as they perhaps should have been," Manfred Jaeger-Ambrozewicz of the IW Cologne Institute for Economic Research told Deutsche Welle. "The result is, there is not a lot of credibility to the test."

To be sure, European banking regulators and governments are in a tough position. If many banks were to fail the tests, confidence in the banking system could be severely undermined.

However, if the outlook is too rosy, it raises suspicions that the test was a breeze, and useless in indicating the banks' true abilities to withstand future shocks, particularly in relation to the sovereign debt held on banks' books.

"But when you decide to ask a question, you have to be able to live with the answer," said Jaeger-Ambrozewicz.

Different rulebooks

Part of the problem, analysts say, is that in Europe the test criteria have not been clearly set out and consistently defined. The tests are being conducted by the Committee for European Banking Supervisors, a body made up of regulators from the EU's 27 member states. There is concern that different countries could use different methods to test their banks.

According to Nicolas Veron, a senior fellow at the Brussels-based research organization Bruegel, the tests will only be successful if they are "based on a single scenario and a single methodology."

"If the outcome is to be credible, it will necessarily reveal significant capital shortfalls in a number of banks," he said.

But it is looking like that will not be the case.

The Association of German Public Sector Banks, which represents many of the nation's troubled financial institutions, said Tuesday that they did not expect their banks to have any difficulty passing the tests - a statement which has raised eyebrows.

Similar news about banks' robust health has emerged from France and Italy. Over the weekend, the director of the federation representing Spain's "cajas," or savings banks, said they had all been profitable at the end of June, although analysts largely see them as extremely vulnerable.

The only German bank that is likely to fail is Hypo Real Estate (HRE), the now nationalized property lender whose troubles have been widely known.

"If HRE is the only German bank that fails, that completely discredits the tests - not just for Germany but for the whole of Europe," a senior banking analyst told the Financial Times.

If most European banks do pass, the amount of new capital that regulators demand be pumped into the system to cushion it from future blows will be minimal.

Successful US testing

The European stress test exercise comes in the wake of an earlier US effort to instill new confidence in its own battered banking sector. In February 2009, US regulators announced they would test the health of the major financial institutions that held two-thirds of the American banking system's assets.

The US Treasury Department test guidelines assumed that the US economy would contract by 3.3 percent in 2009 and remain nearly flat in 2010. They also assumed a sharp drop in housing prices and a rise in unemployment. Regulators there released a detailed description of the assumptions and criteria included in the tests, which gave investors more clarity.

When the results came in, 10 banks were told to raise $75 billion in capital and bank stocks began to climb as investors' fears eased.

But in Europe, there are complaints that transparency is missing, that the tests are assuming better economic performance than is warranted, and that sovereign debt held on banks' books is not being taken into consideration as it should.

"I find that all a little suspicious," said Jaeger-Ambrozewicz. "These tests might tell us about banks' short-term ability to handle a few shocks. But I wonder about their ability to give us an indication of the long-term perspective on banks' health."

He concedes that the tests do have value, but says the design problems mean they will not provide the amount of information the markets had hoped for and are unlikely to bring about the kind of calm and reassurance observed in the US.

Author: Kyle James
Editor: Sam Edmonds