Cause and Effect in European Politics and Law

These stressful stress tests...

Ralitsa Kovacheva, July 26, 2010

A Friday summer evening in the end of July. Europe is dozing exhausted by the heat. People are preparing for their first evening drink.

Meanwhile in London, a few men in suits, with authoritative look and with a medley of concern and relief, visible on their faces, are waiting for the countdown. And at 18.00 CET they announce that the banking system in the EU has passed the stress test. Only 7 banks have remained under the capital barrier of 6 percent, provided that it is a benchmark of the test, not a legal requirement (which is 4%).

These 7 banks are Germany's Hypo Real Estate, the Greek ATEBank and 5 Spanish regional banks (the so-called "cajas”) - Diada, Espiga, Bianca Civica, Unnim and Cajasur. The Committee of European Banking Supervisors (CEBS) explicitly states that the markets should not interpret these results as a sign of banks insolvency, but these institutions must take measures to strengthen their capital positions. According to the official report of the Committee, the competent national authorities are in close contact with banks in order to evaluate the test results and the possible need of recapitalization.

The procedure of announcing the tests' results was being clarified many times. Eventually, it became clear that, first, CEBS will publish a summary report on the results of all 91 banks from 20 countries undergoing the test. (In the other 7 countries over 50 percent of the market is held by subsidiaries of large European banks, undergoing the test, and other institutions therefore were not included). Once the overall results were reported by CEBS, a publication of detailed results by countries and by banks has begun. An hour after the formal announcement of the outcome of the tests, the representatives of CEBS, the European Central Bank and the European Commission gave a briefing, which was the first official comment on the results.

"The results of the test confirm the overall resilience of EU's banking system to negative macroeconomic and financial shocks, and are an important step forward in restoring market confidence.” The organisers of the tests once again emphasized on their transparency, extension and severity in response to criticism that the tests were not sufficiently severe.

For the purpose of the exercise two main scenarios were used for the period 2010-2011. The benchmark scenario provides for a mild recovery of the economy and an inauspicious - a decline in GDP growth by 3 percent, compared to the benchmark assumptions, a sharp increase in interest rates and debt crisis in the euro area with average 8.5 percent reduction in the value of government bonds. It is noted, however, that macroeconomic developments up to date remain in line with the assumptions of the benchmark scenario. The Committee of Supervisors has repeatedly stressed that the test assumptions should not be perceived as forecasts. According to the ECB, the likelihood for realisation of the negative scenario is 5 percent - in comparison, last year's stress tests in the US were conducted at 15 percent probability.

One of the most serious criticism of the analysts was that even the inauspicious scenario was not sufficiently severe and did not address the main question - how would banks cope in the case of a state failure in the EU. According to the Vice President of the ECB Vítor Constancio, it would be a contradiction to assume a failure of any country, given the EU has taken steps (including launching the rescue fund for the euro area - EFSF) for this not to happen. So that situation does not appear in tests. "I think these stress tests are more extensive, more severe, than have been conducted in [other] developed countries on such a scale", Constancio said.

The results are good but do not give grounds for undue relaxation, CEBS commented in its report: "The aggregate results suggest a rather strong resilience for the EU banking system as a whole and may appear reassuring for the banks in the exercise, although it should be emphasized that this outcome is partly due to the continued reliance on government support for a number of institutions. However, given the uncertainties over the actual path of the macro-economic recovery, the result should not be seen as a reason for complacency.”

According to CEBS, in an inauspicious scenario, the total cumulative losses from the stress test would reach 566 billion euro over a two-year time horizon. The banks' aggregate tier 1 capital ratio would fall from 10.3% to 9.2%.

Despite the positive assessment of the results, expressed by Brussels and by individual Member States, analysts remained skeptical, saying that there are no guarantees neither for transparency nor for a consistency in tests applying. Although these were announced as uniform and transparent, the stress tests of European banks are “neither uniform, transparent or stressful enough”, Financial Times wrote, although acknowledging that "it is a good step forward – if treated with caution.”

The biggest problem is not even in the lack of severity, but “the uncertainty over how consistent the methodology was since national regulators supervised the testing”, the newspaper noted. “That non-systemic banks fail is not a national disgrace but a healthy part of capitalism”, FT stated and recalled that the major purpose of the tests was to provide complete information to investors and taxpayers of the state of each bank.

Now the reaction of the markets is expected on Monday morning. Probably markets will react with caution and rather skeptically. Because, as the first comments have shown, the distrust is not simply in the ability of financial institutions to cope with a new debt crisis. It is a lack of confidence in politicians (both national governments and European institutions), on which depends, on the one hand not to allow this and, on the other - to recognize the risks involved. So far, the impression is that they cannot do the former and are not ready to recognize the latter.