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Scepticism Over Stress Testing of European Banks

The results of the bank stress test in Europe have been greeted with widespread skepticism; even though financial markets seem calmer, the system is not yet out of the woods.

Last month, the Committee of European Banking Supervisors carried out what is known as a ‘stress test exercise’ in order to determine how well the principal European banks could hold up in the event of a replay of a major financial crisis. The Council of the European Union had told it to do so in the wake of the chaos following the panic of 2007-08. In the event, 91 banks were tested and seven failed: five in Spain, one in Germany, and one in Greece.

However, leading financial analysts in Europe have scoffed at the results and dismissed them as misleading or worse.

Anthony Harrington, a Contributing Editor to Bloomsbury’s QFinance and twice honored as UK Financial Journalist of the Year, tells ISN Security Watch that even if the stress tests “have not convinced either the press or market commentators,” nevertheless “if their real aim was to calm the markets, they have fulfilled their purpose.”

The manner in which the stress tests were conducted does not account for all the esoteric financial instruments that led to the crisis in 2007-08. Moreover, the absence of a scenario that includes sovereign default (i.e. bankruptcy by a state) could well be considered a significant shortcoming.

Harrington views this criticism, however, as being ill-placed and “pushing stress tests into the realm of catastrophe testing. How impregnable do you want your banks to be?” he asks before continuing: “The point is not to ensure that no bank fails, it is to ensure that there is an orderly procedure for resolving failure.”

And indeed, the creation of a European Financial Stabilization Mechanism (EFSM) with reserves of €750 billion will help those states that cannot help their banks because of their own debt problems.

Not so simple

But it is an open question whether even those reserves will be sufficient if two or three among the countries most at risk - Portugal, Ireland, Italy and Greece (the PIIGs) - require simultaneous recourse to the EFSM. It is possible that even that amount could prove insufficient.

Harrington says that “the major unknowns with respect to each bank’s understanding of its own exposure to toxic assets of the residential mortgage-backed securities variety, has faded as an issue.” This does not mean that not all the toxic assets are gone, but “they are now a known quantity even if it is a quantity that each bank is playing very close to its chest.”

At the same time, European policy has begun to tilt more and more, despite initial French opposition, towards a tightening of fiscal policy and ending of the stimulus programs introduced in order to surmount the 2007-08 crisis.

Thus the day the results of the stress test were made public (it had originally been planned to keep them secret), European Central Bank President Jean-Claude Trichet’s op-ed in the 23 July Financial Times argued for terminating the economic stimulus programs and imposing rigorous of austerity measures across the Continent. This represents the German position put forward at the G-8 and G-20 meetings held in Canada at the end of June and opposed by the US administration.

Austerity and the debt crisis

Intentionally or not, such a policy, which would include raising interest rates while assuring the banks of enough capital to keep them on a steady footing, responds directly to the interests of the financial industry.

Harrington remarks that “the European banking system, even in Europe’s strongest economy [Germany], which also happens to be its biggest exporting nation, is not exactly out the woods. However, I do not expect it to implode if Europe plods along in a sluggish, near zero-growth mode.”

“Borrowing cheap and lending dear generates a huge volume of money for banks, even after you factor in the risks of lending in a sluggish economy,” he adds.

Harrington does not agree with those who criticize the euro as being divorced from the ‘real economy.’ Rather, he says, “The euro is quintessentially a trading currency tightly coupled to the real economy. Its weakness is that it is the result of a monetary union unsupported by any fiscal union.” However, he doubts that EU can “conjure up” a fiscal union after the fact to undergird the euro.

The debt crisis and the euro

Consequently, for Harrington, the strength of the euro ultimately depends upon Europe’s productivity and its export strength, as well as on “market jitters over sovereign debt.”

For the moment, however, concerns over sovereign debt cannot be separated from concerns over the banks. This is why the EU decided to save Greece from sovereign default despite emotional declarations in the press that Athens should suffer the consequences of its behavior.

Even for Greece to suspend payments again would “put huge strains on the euro [and] ... also have a massive impact” on important banks “as fears about the PIIGS generally take wing again,” says Harrington.

Moreover, “if instead of asking about financial instruments, you focus instead purely on two varieties of debt, namely commercial property debt and sovereign debt, the problems in combination have a vaguely Armageddon feel about them.”

The sufficiency of the EFSM thus comes again into focus as a crucial linchpin holding the system together.

By Robert M Cutler

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