Last week European regulators released the much awaited results for bank stress tests that were conducted recently. The tests encompassed 91 key banks representing approximately two-thirds of banking assets in the EU. 

Headline results showed that only 7 banks failed the tests and require in aggregate EUR 3.5 billion of capital to shore up their balance sheets. On the surface this looks a good result. Recovery Partners was interviewed last Friday on this issue just as the results were being officially released to the markets.  The televised discussion can be accessed by clicking on the following links for Part 1 of the interview as well as Part 2. An abbreviated version can be accessed on the Recovery Partners website by clicking on this link.  

This exercise was designed to allay market fears of a banking crisis in Europe stemming from potentially large cross border exposures to governments and banks in the PIIGS and elsewhere. As a  rationale for this very expensive and complicated survey, this explanation alone should give some pause. The authorities are clearly fearful of contagion, banking markets in the EU remain non-functional in a number of important ways and liquidity and trading volumes in the inter-bank markets has slumped and continues at a low ebb due to counterparty credit risk concerns.

Since this exercise was largely conducted to allay fears, our opinion is that the rigor and thoroughness required to bottom out any risk issues was not applied in sufficient measure to give the markets any kind of real comfort at all.

Here is a summary of our concerns:

• The economic scenarios were extremely benign and did not “stress” obligor credit risk sufficiently;
• There was no explicit modeling of sovereign default risk;
• There was no credit modeling of the ECB portfolio which has been significantly degraded in terms of credit risk since the EU Sovereign debt crisis began;
• The Loss Given Default modeling for specific country debt was only applied to bank “front book” (ie trading room) exposures and not to the typically much larger “back book” (buy and hold) positions. This does not make any sense from a credit risk and capital adequacy standpoint which is what this exercise was presumably intended to investigate and measure;
• There was no explicit modelling of liquidity risk and rollover risk which is what the authorities in Europe are very worried about. Over $5 Trn. of bank debt matures in the next 36 months and must be rolled over in the markets in order that the banks can maintain activity. This heavy re-financing calendar is in addition to any fresh capital raises planned by the banks.

Our view on this is that the design of the exercise and transparency of the results and admissions suggest to us very strongly that this was largely a PR exercise rather than a vigorous effort to separate the wheat from the chaff. Therefore trying to assess credit risk and market vulnerabilities amongst European banks using this stress test as a guideline still leaves the markets with considerable uncertainty. The following table which details a portion of the cross border exposures gives an indication of the scale of the potential problem. 

At Recovery Partners it is our belief that this situation will require several more months to play out before market confidence either is re-built and markets stabilize, or the weak sisters begin to drop by the wayside as a function of the, by then ongoing, unsettled funding conditions. The latter scenario might of course be accompanied by renewed and heightened fears of Sovereign defaults. As a final observation, we are unsure as to whether additional confidence boosting measures are planned by the authorities in Europe. If there are some in the works, then a lesson to be taken away from this exercise is for them to be a bit more open and rigorous, lest the market feel that it is being “played” a second time. In that case the market reaction would likely not be as muted and could well feature significant blowback to the detriment of the European banks and the markets there in general.

“There are still inherent funding problems within the interbank market. If the stress tests were designed to basically solve those problems, I think they’ve failed,”  Micheal Hewson, CMC Markets

This entry was posted on Tuesday, July 27th, 2010 at 1:58 pm and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.