More on the Coming European Bank Stress Test Fiasco

We noted a bit more than a week ago that we expect the European banks stress tests to backfire. The US version was a successful con game because the officialdom provided adequate disclosure about the process and stayed firmly on message, the banks were allowed to “manufacture” as analyst Meredith Whitney put it, impressive earnings, putting a tail wind behind their stock prices, and there was a mechanism for the US to inject capital if banks who were directed to raise equity levels were not able to do so.

We pointed out these conditions were not likely to be operative in the case of the Eurobanks, with the most obvious likely gaps a unified strategy among European leaders (this has been notably absent so far; why should the banks be any different?), doubts about whether there is enough “stress” in the stress tests (due either to insufficient transparency or overly generous macroeconomic assumptions), and most important, lack of a credible equity injection mechanism. In Germany, perceived to be the strong man of the EU, the size of its banking sector is so large relative to its GDP as to raise doubts about its ability to backstop its banks. Moreover, the German population is dead set against further bailouts.

Today, the Financial Times reports that the stress tests will be conducted on 100 banks, with details that were not encouraging:

The number of European banks subjected to stress tests is likely to rise, with sources suggesting that as many as 100 institutions will be involved in a broader exercise to shore up market confidence.

European Union leaders have already agreed to publish stress test results for 26 banks next month – mainly big, cross-border institutions – to address concerns about the eurozone’s exposure to sovereign debt.

But one German government official said those tests, which are being conducted by the Committee of European Banking Supervisors (CEBS), would be expanded to cover “significant market share” in each market – about half of all bank balance sheets in each country.

While the total number of financial institutions to have stress tests published remained open, the German official also said the country’s eight Landesbanks had agreed to publication.

The weakened Landesbanks had resisted publication until now, arguing that testing their ability to withstand sovereign defaults would send the wrong signal to bond investors.

The German government had supported this line but has come round to viewing publication as a potentially important confidence-building exercise.

Yves here. How pray tell do you “build confidence” by exposing the dirty laundry of sick banks? Pretty much everyone knows the Landesbanken are in bad shape.

We had also warned that coming up with credible stress levels would be problematic. Given the wide differences in economic performance among the eurozone member nations, it would make sense for each country to set its own metrics. But then you would need to have them trade notes and recalibrate, possibly renegotiate (since one country adopting tougher relative standards could make the rest look bad).

Instead, the eurozone appears to be adopting a “one size fits all” standard, which is not credible:

CEBS has said the parameters were being set at a pan-European level, despite suggestions from several banks that have been tested that the stress scenarios were nationally specific.

In a limited exercise last year, CEBS said its stress scenario involved a 2.7 per cent fall in GDP this year and 12 per cent unemployment.

Yves here. Ahem, unemployment in Spain is already at 20%. So we are seriously going to set the stress test level at 12%? No wonder the Spanish banking minister was so keen to publish results (I assume the test on Spanish banks was less nonsensical, but I could be wrong here).

The story indicates that analysts are already skeptical:

But one top banker said that even if the list were expanded it would not serve the purpose of sufficiently reassuring the markets. “You need total transparency,” he said. “You need to publish the results of the entire banking system – otherwise, suspicions will remain.”

Wolfgang Munchau, in a Financial Times comment (hat tip readers Don B and Swedish Lex) raises more general concerns about ongoing efforts to shore up the eurozone. The first part of his piece describes a staggering gulf in perceptions: eurozone officials who genuinely believe their salvage operation is going well, versus investors who see continuing disarray, last minute expedients, a failure to address significant, fundamental issues, and therefore see a breakup as inevitable.

Munchau turns to the the stress tests as what he expects to pan out as another example of poor planning and undue optimism by eurozone polcymakers:

I only hope that they know what they did when they recently announced the publication of the stress tests for 25 banks. Once these are published, the markets will immediately demand to see the tests for all banks. Once that happens, in turn, governments will need to produce a convincing recapitalisation strategy. I fear, however, that they are once again committing themselves to going down a road without a map.

Without an endgame, this exercise will end in disaster. At some point the markets will realise that large parts of the German and French banking systems are insolvent, and that they are going to stay insolvent. You might think that Europe’s policy elites cannot be so stupid as to commit themselves to stress tests without a resolution strategy up their sleeves. But I am afraid they probably are. Europe’s political leaders and their economic advisers are, for the most part, financially illiterate.

Is there a way out? Yes there is, but the chance of a resolution to the crisis is starting to fade. The first step would have to be a serious attempt to resolve bank balance sheets. This is as much a German and French banking crisis as it is a Greek and Spanish debt crisis. You need to resolve both problems simultaneously. Resolution would require a large fiscal transfer, not from Germany to Greece, but from the German public sector to the German bank sector – in the form of new capital. The same would apply to France.

Beyond this restructuring, the eurozone will need to commit itself to a full-blown fiscal union and proper political institutions that give binding macroeconomic instructions to member states for budgetary policy, financial policy and structural policies. The public and private sector imbalances are so immense that they are not self-correcting. And you have to be very naive to think that peer pressure is going to resolve anything.

There is no point in beating about the bush and issuing polite calls for the creation of independent fiscal councils or other paraphernalia. This is not the time for a debate on second-order reforms. I am aware that, at a time of rising nationalism and regionalism throughout the EU, there is no consensus for such sweeping reforms. But that is the choice the EU’s citizens and their political leaders will have to make – a choice between reverting to dysfunctional and, as it transpires, insolvent nation states, or jumping to a political and economic union.

Yves again. Munchau is clearly not optimistic that EU leaders recognize the magnitude of the challenges to achieving a better union. Not only has wearing rose colored glasses blinded them to the difficulties before them, but it has also led them to fail to prepare their citizens adequately. That almost assures a popular backlash even if the officialdom were to get religion late in the game.

Originally published at naked capitalism and reproduced here with the author’s permission. 

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