What’s at stake: Hoping to repair shattered confidence in the health of its financial sector, the European Union agreed Thursday to publish the results of stress tests imposed on 25 major banks operating across the borders in the 27-nation. The decision became necessary as the previous strategy – consisting of ECB bond purchasing programme, the erection of a financial shield, and austerity programme – failed to impress financial markets which started to treat the European sovereign debt crisis as a banking crisis. By agreeing to publish “stress tests” on banks, the EU hopes to ease investors’ fears about European lenders and unfreeze wholesale financing. But while most of the biggest names in European banking are covered by the agreement, it will not shed light on the financial health of the hundreds of smaller savings or public-sector institutions that dominate the consumer banking market in countries like Germany.
The keys for the exercise to raise confidence
Miguel Ángel Fernández Ordóñez, the governor of the Bank of Spain, announced that stress tests would be published covering all Spanish banks. That includes tests on the troublesome cajas – credit co-operatives that are often controlled by powerful local politicians and which have been resisting pressure from Madrid to merge and restructure. The tests will cover not only for what would currently seem to be the most reasonable scenarios, but also for complex growth scenarios in the near future. If by the end of June, any institutions are still resisting restructuring and recapitalisation by the FROB (Fund for the Orderly Restructuring of the Banking Sector), then the central bank will act. That is no idle threat: the FROB mechanism allows the central bank to take over recalcitrant banks, as happened with the church-run CajaSur the other day.
Alastair Gray of UBS wants to see some failure in the mix. Without a significant proportion, by assets and number, failing, the tests potentially amount to little more than an empty gesture. In US stress tests over half of participants failed. The ’successful’ US stress tests, which are commonly associated with a turning point in US bank equity prices and better fixed income markets, saw over half of participants fail. The US$75 billion in common equity they raised in the following weeks was the key to the exercise raising confidence. The UK bank stress tests (there were several) saw the banks required to raise almost £50 billion in common equity. All banks ended up with some equity need, with the extremes close to £30 billion for RBS and less than £1 billion for HSBC Bank. The Irish tests saw all banks needing equity uplifts of 50% or more of their existing base.
FT Alphaville reports that according to feedbacks Morgan Stanley economists received from policy-makers and banks, the stress tests will be based on harsher economic assumptions – apart from sovereign exposure. They expect the CEBS [Committee of European Banking Supervisors] tests to be harsher than last October’s, which were much less stringent than the US stress tests (e.g. min tier 1 ratios in the US tests were 50% higher than in the European). The last CEBS test was done with minimum of Tier 1 of 4% (2% below the US stress test of minimum Tier 1 of 6%).
Erik Nielsen is a bit worried whether we are being set up for a disappointment. There is a big risk that market participants’ expectations of methodology and assumptions for the tests may be out of sync with what policymakers are preparing. Specifically, do the two sides agree on how to value the banks’ sovereign holdings? Or their real estate holdings? The additional information and transparency will be good, and the subsequent capitalisation will be welcome and move things in the right direction, but he worries that markets might not be satisfied unless the system gets measured against extreme tail-end events, which is not likely.
Banks’ exposures to PIGS
The Bank for International Settlements (BIS) put out its Quarterly Review last Monday. As part of the review, the BIS estimated the exposures of banks by nationality to the residents of Greece, Ireland, Portugal and Spain. French and German banks are the most exposed to debt from Spain, Greece, Portugal and Ireland. French banks had lent $493 billion to businesses, households and governments in the four countries by the end of 2009 while German banks had lent $465 billion. The exposures of BIS reporting banks to the public sectors of the euro area countries facing market pressures can be put into perspective by comparing them with these banks’ capital. The combined exposures of German, French and Belgian banks to the public sectors of Spain, Greece and Portugal amounted to 12.1%, 8.3% and 5.0%, respectively, of their joint Tier 1 capital. By comparison, the combined exposures of Italian, Dutch and Swiss banks to the same public sectors were equal to 2.8%, 2.7% and 2.0%, respectively, of their Tier 1 capital.
Mark Copelovitch, Professor of Political Science and Public Affairs at the University of Wisconsin, notes that varying levels of exposure to indebted European nations may colour how future bailouts proceed. Despite the heated rhetoric by Angela Merkel, Nicolas Sarkozy, and others about the need for the PIGS to put their own house in order by imposing staunch austerity measures, we are quite likely to see even stronger support for Spain (and Ireland), given its importance for the profitability and solvency of French and German banks. Portugal, in contrast, is likely to fare worse than Greece, given its limited importance for the major eurozone (and G-5) banking sectors. At the same time, we are also likely to see tensions within the IMF over the size and terms of any contribution to future PIGS rescue packages, given that American and Japanese views about the importance of eurozone bailouts are colour by their own, less extensive, financial interests in these countries.
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