Cause and Effect in European Politics and Law

Will banks endure an alien attack?

Ralitsa Kovacheva, July 28, 2010

“If you tried to test the safety of cars or children’s toys using the same method the European Union applied in its stress tests on banks, you would end up in jail. How so? Simply because the testing mechanism was calibrated to fix the result. The purpose of the exercise was to ensure that the only banks that failed it were those that would have to be restructured anyway.”

This what the Financial Times columnist Wolfgang Munchau writes in an acute comment on banks' stress tests. As you know, the test results of 91 European banks were published on Friday evening, but the first reactions of the markets were expected on Monday. While signals are encouraging, analysts continue, as at the outset of the tests, to be particularly critical to the way they were conducted. “The purpose of this cynical exercise was to pretend that the EU was solving a problem, when in fact it was not”, Munchau notes.

According to him, there are three main problems with the stress tests. Firstly, these have not included some important institutions with unclear financial health. The second problem is the definition of the pass rate – a tier-one ratio of 6 per cent. This definition tells us nothing, Munchau claims. The Tier one capital includes equity and retained earnings but also various types of hybrid debt instruments, the economist explains, for example, government support from Germany and Spain comes in the form of hybrid instruments. “The current definition of tier one capital is the reason why all the German Landesbanken have passed the tests. If one had used a narrower definition – equity and retained earnings only – the results would almost surely have been different.”

The third and the most serious problem is the credibility of the tests given the lack of provision for the possibility of sovereign default. “Nobody is asking the bank supervisors to stress-test the impact of an alien attack. But sovereign default in the case of Greece is not such a far-fetched scenario – even if you believe it to be unlikely. It is irresponsible for the stress testers to ignore that sort of event. That is like a car crash tester failing to consider the possibility of an oncoming vehicle.”

Even in these 5 percent likelihood of fulfillment of the adverse scenario, assumed by the European Central Bank, the probability of a partial Greek default exists, Munchau says. He accuses the EU of carrying out the stress tests in the same superficial way as it has treated the financial sector in the midst of crisis. “The EU’s approach to the financial sector has been to apply patchwork fixes – a blanket bail-out, some not very serious recapitalisation plans, plus loads of liquidity – rather than solve the problem.” In the stress tests' case, conducting these without a resolution strategy is entirely pointless, the economist concludes.

According to him, a notable exception is Spain, where the situation is the most severe, and where a serious attempt is under way to address it. “But while in Madrid the stress tests are part of a political commitment to resolve the banking problems that is not the case elsewhere.”

As you know, Spain has decided firstly to disclose the test results of its banks, as part of the measures to deal with the serious financial problems of the country and the pressure from the markets. Just a day later, the European Council on June 17 decided to make it in all EU countries. In the end, however, after long haggling what exactly the methodology of the tests should be and especially what part of the results should be published, it appeared that some of the most important questions will remain unanswered. For example, banks' exposures to sovereign debt, which would give a clear idea what will happen to them in case of a sudden devaluation of government bonds or a bankruptcy - an option that has not appeared in the test.

Which again raises the question what kind of drivers the European politicians are. As Munchau says, you cannot drive a car, without assuming that the oncoming vehicles may not have lights, or their breaks may refuse, or these may simply be driven by irresponsible drivers. Whatever the reason is, the result can be a crash.