A small portion of banks recently failed EU stress tests involving three different economic scenarios. Some experts have criticized the tests for failing to include a sovereign default situation, which they believe would have resulted in many more banks being identified as “at risk” or “failing”. See the following article from Money Morning for more on this.
The European Union (EU) bank stress tests failed to account for a sovereign default, meaning results show a healthier banking sector than actually exists.
The tests results were released Friday with seven banks failing, but analysts say many more institutions could have failed if the tests simulated a sovereign default. Testing regulators from the Committee of European Banking Supervisors (CEBS) decided against testing securities held in lenders’ banking books, where sovereign debt is held and only written down in the case of default.
“The long awaited stress tests do not seem to have been that stressful after all,” said Gary Jenkins, an analyst at Evolution Securities Ltd. “The most controversial area surrounds the treatment of the banks’ sovereign debt holdings.”
Banks hold about 90% of Greek government bonds in their banking book and 10% in their trading book, according to a survey by Morgan Stanley (NYSE: MS) analysts. They only write down the bonds in banking books when there is serious doubt that a state will be able to repay its debt or make interest payments, which European leaders deemed “unthinkable.”
“The tests need to be across the board – including the banking book,” Andrea Williams, an asset manager with Royal London Asset Management, told Bloomberg. “It does undermine the whole credibility of the tests.”
The stress tests did test a scenario with a haircut on government debt, and assumed a loss of 23.1% in Greek debt, 14% in Portuguese bonds’ value, 12.3% on Spanish debt, and 4.7% on German bonds. But the value on the banking books was not considered.
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Not testing the banking books “allows banks to basically underestimate their exposure to distressed peripheral debt,” Win Thin, a senior currency strategist at Brown Brothers Harriman, wrote in a note to clients Friday. “By leaving out stress tests on the banking book, then a true picture of bank balance sheets will clearly not be obtained.”
The tests also failed to test if banks were holding enough liquidity buffers to meet future payment obligations and remain solvent.
The CEBS’s tests included three economic scenarios. The first was a “benchmark” scenario using current estimated growth forecasts for 2010 and 2011.
A second scenario simulated adverse economic conditions of European Union economic output 3% lower than expected, with a 1% decline in 2010 and 2% decline in 2011. It assumed short-term interest rates would rise by 1.25 percentage points and long-term rates were up 0.75 percentage point, with investor anxiety similar to the height of the financial crisis.
CEBS said the probability of this scenario occurring was 5%.
Another adverse scenario added a sovereign debt shock. It simulated worse bond market turmoil than experienced in May 2010, when Eurozone bond yields widened against German bunds. The test added an average 0.30 percentage point widening in long-term yields to the maximum spread from May.
In a compromise to not simulating a sovereign default, banks were scheduled to detail their holdings of Greek, Spanish, Portuguese and other sovereign bonds, limiting speculation over banks’ exposure. But the banking supervisors’ report did not contain that information.
Among the seven banks failing the tests out of the 91 tested were Germany’s Hypo Real Estate, Greece’s ATEBank, and five Spanish savings banks. The banks need to raise $4.5 billion total to meet capital requirements.
Several other banks narrowly passed, meaning testing the banking books could have resulted in more failures and a greater restructuring of Europe’s banking sector.
“It would have aided credibility if there had been a higher number of fails and a higher amount of capital raised,” Jon Peace, a London-based analyst at Nomura International Plc., told Bloomberg. “People will be surprised that it is as small as that.”
Fueling skepticism over the tests’ effectiveness is the passing scores of German’s nine state-controlled landesbanks. They all lost billions in subprime assets and poor investment choices in the financial crisis, and analysts generally regard the banks as poorly managed.
Bank share prices should reflect next week whether or not investors are confident in the tests’ results. Interbank lending should also rise if lenders regain trust in other banks’ creditworthiness.
This article has been republished from Money Morning. You can also view this article at Money Morning, an investment news and analysis site.