#EU #banking stress tests — the good, the bad, and the ugly
Among the many articles written regarding the outcomes of EU stress tests released today, this piece from the New York Times/International Herald Tribune focuses on the implications for the “healthy” banks that passed. It is a good perspective, not because it quotes me, but because it focuses on the important issue of the implications for the European banking sector going forward rather than playing the name game of which sacrificial lambs were permitted to fail.
Beyond the analysis in the article, here are a few more observations on details not yet seen in the early stories covering the stress tests.
The Good: The sovereign bond haircuts were published on a disaggregated basis both by country and by scenario. In addition, banks from several key countries (Italy; France; Spain) specified the distribution of their sovereign bond holdings not only by country but by whether the holdings are in the banking book or the trading book. In addition, the process by which the haircuts were calculated also were disclosed. Finally, the banking book was also stressed. This last point is important given that most EU sovereign bonds are reported held on banks’ banking books (which are not subject to mark-to-market or fair value accounting). Providing insight into the standard country-by-country values used for PDs and LGDs in the banking book under both the baseline and adverse scenarios eliminates a criticism that only part of the bank’s holdings were stressed. Given the general reluctance to publish any bank-specific results prior to today, these disclosures at this level of disaggregation are a step forward for transparency in Europe even if the actual data and assumptions are far too rosy.
The Bad: Not every bank disclosed the distribution of holdings of sovereign bonds, most notably banks in Germany. More importantly, the calculation method for the haircuts and default probabilities leaves much to be desired, to say the least. The sovereign bond haircuts, PDs and LDGs were all based on sovereign CDS spreads as of year-end 2009. That’s right, 2009. Very disappointing. And probably not very realistic of stress levels even today.
The kind interpretation of course is that sovereigns cannot officially and publicly assume the absolute worst. Last year’s US stress tests assumed unemployment rates last year for the adverse scenario that were already outdated when the stress tests were released. So the EU is not alone in generating stress tests with assumptions that seem rosy in comparison with prevailing market conditions at the time the stress tests are released. The difference is that the vast majority of credit intermediation runs through banks in Europe, so the banks are far more important to economic stability and growth there than they are in the United States. The less kind interpretation is that policymakers in Europe reject the signals the market has been sending regarding potential sovereign default and so choose as their starting point a more neutral starting data point (sovereign CDS spreads at end-2009) that is not corrupted by “inappropriate” volatility. Either way, using such outdated data as the basis for calculating haircuts, PDs and LGDs throughout the stress tests invites attempts at reverse engineering based on today’s market conditions.
The Ugly: The EU’s Financial Services Action Plan years ago successfully created a cross-border banking network in Europe focused predominantly on wholesale lending to corporates. Today’s results do not assess the impact that stress on the parent could have on its subsidiaries and affiliates. Also, the results provide no hint of the potential funding stresses in the European banking system embedded within banks’ cross-border networks. IMF and BIS research has made clear this year that failure to assess stresses on funding throughout an organization risks missing key vulnerabilities. This is not a hypothetical situation.
Take Hungary as an example. One of the consequences associated with cessation of the IMF program there is that the Vienna Initiative is in doubt. The Vienna Initiative crafted a cooperative agreement between banks and the official sector in which parent banks agreed to serve as a source of support for their affiliated entities in IMF program countries, regulators agreed to support these initiatives despite the pressure it might put on regulatory frameworks, and the IMF agree to provide liquidity to the program countries. With the IMF program in Hungary currently itself in crisis, real questions arise regarding how banks will continue to serve as sources of support for their affiliates in that country…and thus implicitly provide stability to the overall economy. The IMF statement released yesterday after meeting with bankers and the European Commission indicates that this is no idle worry.
But overall, the release of so much information when many governments sought to avoid such disclosures can only be counted as a success for Europe. Noone really needed these stress tests to tell them that vulnerabilities exist in the European banking arena. These stress tests provide a window into the scope of support the official sector is willing to extent to the banks. Will that create sufficient comfort in the banking sector to stabilize interbank funding rates? We are about to find out.
