The failure of the European bank stress tests: Officialdom and “thought-bubbles”

Last week was one which was full of new information for financial markets. Some of it of course was rather regurgitated as the Chairman of America’s Federal Reserve gave a speech to Congress which in the main repeated issues discussed in the minutes of the last Federal Reserve Meeting and minutes from the Bank of England which told us that they too were more uncertain of the future than usual. Uncertainty is becoming the new buzzword for central bankers is it not? We also saw a week in which world stock markets continued a recovery from the recent lows. The American Standard and Poors index for example fell early on Tuesday to below 1060 but ended a strong week at 1103. The most curious part of the equity moves was that earlier in the week they appeared to fall on good news and rose on bad. Either way it was a good week for them.

The UK

The UK had some genuinely good news at the end of last week or if I include the stress tests which reviewed UK banks very favourably with bankers at Barclays bank particularly wreathed in smiles I would imagine. A somewhat different result than what the real world stress test did to them some two years ago if you recall but remember Friday exchanged the real world for the views of European officials and civil servants! Anyway the economic growth figures were excellent with growth as measured by Gross Domestic Product rising by 1.1% and just to be clear this is for the quarter not on an annualised basis.

Breaking the numbers down revealed that construction spending grew by 6.6% and was responsible for 0.4% of the growth. I have been looking into this and it would appear that we did see a surge in the second quarter in this area but that quite a few factors were at play. For example the snow and bad weather in the first quarter shifted work into the second quarter and public spending was strong. So much so that it is not impossible that this figure apparently could be revised up (to create even more of a shock). However this is considered a peak as in essence going forwards we will have to see if private sector spending can rise enough to cover the retrenchment of the public sector. The real detail on this comes from a specialist blog called (probably unsurprisingly) brickonomics, however it/he has revised the view that many others quoted.

As a general view whilst the overall news is good it is also plain that the Office for National Statistics has problems with its data and its numbers. There was a considerable debate over when we came out of recession in the summer and autumn of 2009 and now we find growth way above even the most optimistic forecasts. Also this follows straight after the ONS having to delay publication of the final estimate of first quarter growth due to unspecified problems. I start to wonder if the staff cuts have had an impact and it is increasingly looking like an organisation which is in disarray. The way it refused to publish why it had to delay the GDP numbers looked straight out of the playbook of an organisation with something to hide.

A theme I wish to develop today is already in evidence here. When officials or civil servants try to hide something they often do it so badly that you end up with a worse result than if the truth had been told. Of course you also end up with an atmosphere of lack of trust and reduced credibility.

Monetary Policy Committee

One new feature in the UK is that members of the Monetary Policy Committee appear to be queueing up to be interviewed by the press so that they can say that they do not like inflation and that they are absolutely committed to dealing with it. Sadly with one exception their claimed determination to control inflation does not stretch to actually doing anything about it. So we have a verbal campaign it would appear.

As inflationary expectations are an important factor  in dealing with inflation one might argue that they are trying to use an extra tool. However there are problems with this. For a start how many will read it? I would love to tell you that such interviews would be widely read but somehow I do not see it competing with page 3 of the Sun, or the football results. Also those who read such articles are likely in general to be aware of economic issues and accordingly be already aware that the UK’s inflation performance has been both poor and worse than expected over the past few years. Accordingly as they are reminding people of this then the plan to my mind carries within it the seeds of its own failure. For example from an interview given by the Bank of England’s Chief Economist Spencer Dale to the Independent newspaper.

Since the spring of 2006 inflation has been above target for 41 out of 50 months and for two years it has averaged over 3 per cent.”

“Inflation has come out a little higher than expected, and the news on VAT in the June Budget means that the time it will take inflation to get back to target will be pushed out, and I expect it will be above target until the end of next year.”

So having offered the possible explanation that this media campaign is trying to reduce inflationary expectations looking at the detail of it leads me to the conclusion that if anything it is likely to raise them. Why? I am afraid it is human nature as members of the committee are unlikely to admit it but when they are alone in a quiet moment they must be thinking to themselves that their term on the MPC is in danger of being considered a failure. So they are putting out individual statements to try to separate themselves from the group.However yet again such moves lead to everyone being worse off. I am grateful that Fabio Capello is not currently following this trend giving interviews to the press saying that England’s footballers really can pass to each other just like say Spain’s.

The European bank stress tests

I have established this theme today because over the weekend as I had time to review the stress tests in more detail this came to my mind. The thought occurred to me that Europe’s officials probably went home thinking that they had done a good job. I do not mean to imply that they are delusional simply that in my opinion they have trapped themselves in one of the “thought bubbles” I have discussed before. Time and time again we see EU and euro zone intervention which has what I consider to be extraordinary claims made by euro zone ministers and officials. These claims are usually punctured with in a few days yet sooner or later they are back again….

What actually happened?

These officials sat down and did not ask the question, how can we stress test the banking system? What they actually asked in my view was, how few banks can we fail? They in their “thought bubble” would have been in a zone where they saw the US stress tests as having been a success and will have wanted to repeat them as cheaply as possible. Then the markets would be reassured and everything would be better. What never seems to occur to them and lets face it this has happened quite often now is that as time goes by investors will stop and think. As they think they will see holes in the plan. So the pattern is for an inital rally followed by a fall. I find it profoundly disturbing that we have a group of people who appear to be running Europe who do not seem to ever learn from their mistakes.

Flaws in the tests

The most obvious flaw is the tests is the distinction between trading books and long-term holding books at the banks. You see holdings of sovereign debt were subject to a stress test if they were in the first category but not in the second. Now there are several flaws in this.

1. Banks usually hold more in the latter than the former category.

2. An old City aphorism is that ” a long-term hold is a short-term punt that has gone wrong”. Now this year a lot of short-term punts in sovereign debt have gone wrong. For example Greek ten-year government bonds yielded 5.72% as we began this year and now yield 10.58%. Put another way she issued a new ten-year benchmark bond on the 11th March at a price of 98.742 on average, it closed at 74.03 on Friday. That is quite a fall in 4 months. So before this stress tests were a twinkle in an EU officials eye banks would have been likely to have shifted such bonds into a long-term hold. Indeed some accountancy rules in Europe actually encourage this.

3, If you were a bank that is financially weak, once you knew that bonds which were going to be held to maturity would be excluded from the tests what would you do with your worst investments in sovereign debt?

4. Is CEBS actually going to check that the bonds are held to maturity? Is there a list so we can check?

So the sovereign debt section was already a farce before we reach the next part. In the “thought-bubble” of a euro zone official there is no reason to test what would happen if a country (aka Greece) defaulted because the moves they have made make this “impossible”. Indeed a logical man may worry about this conundrum. Default is most likely in the weakest countries. These weakest countries have supported their banks and provided capital. Should they travel along the road for default not only will their banks not have access to future capital from this source what will be the impact on existing capital that has already been provided? There is something of a Faustian flaw here.

Economic Growth

Here the stress test was supposed to model how the banking sector would respond to a double-dip recession. According to CEBS.

The benchmark macro-economic scenario assumes a mild recovery from the severe downturn of 2008-2009, whereas the adverse scenario assumes a “double-dip” recession. For the euro area, the GDP growth under the benchmark scenario is assumed at a level of +0.7 (2010) and +1.5% (2011), whereas under the adverse scenario the euro area would see a decrease of GDP by -0.2% in 2010 and -0.6% in 2011. For the whole European Union (EU27) the benchmark scenario assumes a +1.0% growth of GDP in 2010 and +1.7% in 2011, whereas under the adverse scenario the GDP would not grow in 2010 and would decline by -0.4% in 2011. On aggregate and over the two-year time horizon, the adverse scenario assumes a three percentage point deviation of GDP for the EU
compared to the benchmark scenario. It should be noted that current macro-economic developments remain in line with the assumptions provided in the benchmark scenario.

In other words rather than a fall in GDP over the next two years of say 3% we get a fall of 3% relative to forecast figures. This is not the same at all. In fact it is a rather unlikely outcome and is misleading in my view.

Tier One Capital

Banks have been judged using a criteria of tier one capital and there are two main flaws with this.

1. This includes hybrid capital. You may be wondering what this is well it is capital that has elements of debt as well as equity in it. This leads to the view that they should be excluded as how can debt instruments help in a capital crisis? We are back to officialdom and “thought bubbles” again. Germany and Spain have supported their banks using hybrid capital so it had to be included.

2. Exactly what does having 6% of tier one capital tell us. For example if we raised it to 7% then another 17 banks would have failed.

Conclusion

Officialdom has got the result it wanted. Over the next few days as analysts slave over the numbers we will no doubt see examples of new more realistic stress tests being developed. Some banks will fail these and this has disturbing implications for there is the possibility that the stress tests will make things worse and not better. This is indeed a theme which euro zone officialdom is happy to ignore.

One market measure is already giving us a clue. This morning inter-bank markets have given a signal. Three month Euribor has continued its recent rising trend and is now 0.889%. Still low compared with the post-Lehman crisis but no sign of an improvement.

In reality as I wrote last week stress tests can never fully replicate a real world “stress” which by definition is unexpected and these days is often fast-moving and dynamic but a chance to re-establish some credibility has been missed. Furthermore there was another flaw. These tests dealt with capital (copying the US 2009 tests in this regard) and the current problem is liquidity. But then there is another aphorism “central bankers always fight the last war”.

Sports fans who watched the formula one race from Germany were given further food for thought. The race was manipulated to give a Spanish winner. Those in any doubt of this should have seen Felipe Massa ‘s body language at the end of the race. I have heard of art imitating life but sport? No doubt Ferrari like euro zone officials felt they had been very clever whilst fans were wondering if they had just been cheated.

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6 thoughts on “The failure of the European bank stress tests: Officialdom and “thought-bubbles”

  1. “I am afraid it is human nature as members of the committee are unlikely to admit it but when they are alone in a quiet moment they must be thinking to themselves that their term on the MPC is in danger of being considered a failure.” One would hope so, and they certainly should be so thinking if they have any conscience or realism at all. The question which really has to be asked is who will give them another job once their term with the MPC comes to an end?

    Any professionally-aware recruiter faced with such a track record of blatant failure, to execute such a simple task as their remit dictates, would have to ask whether there are any circumstances under which they could risk employing such people. A potential employer would have to consider the serious risk that people with such a track record will demonstrate the same incompetence or worse yet again. It is difficult for a leopard to change its spots?

  2. Drf, you just want interest rates higher and are trying to justify this wish with bogus arguments. I have read the BoE remit as you suggested and I think the MPC would not be following its remit if it jacked up rates everytime an annual statistical figure increased. As I am sure you are aware the whole process is iterative and their target is CPI in 2 years time.
    There is are 2 major ‘fault lines’ across society. Firstly between those with debt and dependant on a wage; and those with savings and dependant on fixed income. Secondly the poorer 50-80% who support tax increases and increases in state subsidies; and the richer %age who support less tax and less national debt. Its very interesting to speculate the intersections of these groups.
    As far as the EU bank tests are concerned, as stated it can never replicate real world events that are chaotic and becoming more so. So whatever they did or didn’t do its just an academic exercise. Ultimately the credibility of the banks depends on the major economies , particularly Germany and their appetite to continue to support the ‘system’ directly or indirectly through state bale-outs. Do they have any choice? so the German tax-payer knows its ultimately down to him as usual.

    • It seems likely like many others that you have read the BoE remit rather than the MPC’s specific remit under which it was set up, and which has never been formally changed to my knowledge. You will find it embedded within the BoE web-site. The MPC does not have any authority nor responsibility to carry out the much broader remit of the BoE.

      You state that I “want interest rates higher and are trying to justify this wish with bogus arguments”. It seems that you believe that you can read my mind? Perhaps you think you are Psychic? (I would not attempt to make such a categorical statement concerning what you want or think, since I do not profess to be able to read your mind, so I do not know.) If you read my comments again you will not find any statement by me that I want interest rates to be higher. I do not. I would like low interest rates like most other people, but I would also like low real inflation, and I do not want fiduciary meltdown in a Wiemar Republic style. (The ex-prime minister John Major recently suggested that the present real inflation rate is double that declared by the ONS. Well of course he would say that now he is out of office! Nevertheless he has a point. It is clearly higher than the ONS numbers indicate.)

      As Shaun has implied today, the MPC have dismally failed to do the simple task which they are paid to do for now over 2 years. That is my sole point. If you believe this automatically means increasing base rate, then that is your opinion – not my expressed opinion so far. Nowhere is the MPC’s remit expressed or implied to be to control the UK economy to ensure that the reckless do not lose their houses which they paid too much for, nor to avoid the necessary economic correction after the UK’s reckless collective profligacy and engorgement for far too long.

      It takes around 1 to 2 years for any change in base rate to have a full significant effect, so your point concerning time-scale is irrelevant. Any cybernetic system (economic systems are an example) has to be continuously controlled by the input variables if the output is to follow the required outcome trajectory. It is no good leaving control action until it is too late. Then there is meltdown due to inertia.That is exactly what the Wiemar Germans did, then they were surprised when the tide suddenly turned, and it was too late to stop the meltdown.

      From your expressed position it would seem that you are taking the side of net borrowers who are worried about being able to meet their commitments if there were a change in base rate, rather than those who are concerned about the effect which serious inflation will have on the UK economy longer-term, and what the MPC’s remit actually is. (It is possible that their specific formal remit has been recently changed, but I have not seen any evidence of this so far.)

    • JW, your focus on faultlines suggests that the essential issues are distributive. That was the UK’s problem throughout the 1960s and 1970s: distributional conflicts meant less for everyone. (And in my view, Thatcher did not solve the problem; just suppressed it). Looking at Europe now, it seems to me that Germany is in a better position than most other countries and none of the Germans I know has negative equity and none expects to become rich as a result of central bank manipulation of interest rates. Does the UK really have to continue to impoverish itself through unsustainable debt, inflation and low confidence, while fighting like dogs over a bone?

  3. This is a late comment, but I cannot resist pointing to John Kay’s brilliant piece in today’s FT:

    http://www.ft.com/cms/s/0/18156e7c-99ae-11df-a852-00144feab49a.html

    His conclusion:
    Shamefully, the purpose of the stress tests is not to ensure that depositors’ money is safe or that taxpayers will not be called on again. The purpose is to reassure banks and their shareholders that they will not be required to provide significant additional capital. The lesson – perhaps the only lesson – of the stress tests is that Europe’s politicians and regulators have not begun to address, far less resolve, the issues posed by the crisis of 2008.

  4. “Barcelona were in the Champions League final”?

    I would mention this but the tactics in the Inter Milan performance against Barcelona were amazing.

    On the subject what were the economic effects for the UK of Howard Webb refereeing the two big finals?

    Fletch

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