The ECB banking stress tests explained

Today sees something of a novel departure in that the European Central Bank (ECB) has published the stress test results for the European banking system. The choice of day is plainly to give markets the time to analyse and consider the results before they open for business. European equity markets will not be open until tomorrow although the currency markets will be in operation from later on this evening as a new week starts in the Antipodes and Far East.

What is the real purpose of this?

I will discuss the total methodology in a moment but it is in my opinion the third aim of the process which is the driver here.

Confidence building: Assure all stakeholders that banks are fundamentally sound and trustworthy.

The ECB wants you to believe that the European banking sector is safe and sound. I would say as safe as houses but that phrase has not always worked out so well in the credit crunch era! Of course I am sure that at least some of you are wondering why this is necessary in the first place? That is because there are genuine doubts about various aspects of the European banking system. In specific terms we have seen Banco Espirito Santo fail in Portugal and Corpbank or KTB fail in Bulgaria. Those who place their face in deposit insurance may like to know that (h/t Frances Coppola who posted on this yesterday) that the situation I discussed about it not paying out for Corpbank depositors remains true. This deserves much more publicity than it is getting as it poses lots of questions for a system of deposit insurance which is supposed to be European wide.

So as you can see there are genuine questions which the ECB is hoping this will settle. Of course there will be some of you who are already thinking of the words of Jim Hacker or if you prefer Otto Von Bismarck.

Never believe anything until it is officially denied.

Has this been tried before?

Unfortunately for the Euro area authorities yes it has with frankly poor results. There have been two previous efforts by the European Banking Authority and banks which passed its tests then failed which destroyed what credibility it and its tests had.

What are the aims today?

Transparency:Enhance the quality of information available on the condition of banks

Repair: Identify problems and implement necessary corrective actions.

Confidence building:Assure all stakeholders that banks are fundamentally sound and trustworthy.

What are the tests?

Elements
The comprehensive assessment comprises two main pillars:

an asset quality review (AQR) – to enhance the transparency of bank exposures, including the adequacy of asset and collateral valuation and related provisions.
a stress test – to examine the resilience of banks’ balance sheets to stress scenarios, performed in close cooperation with the European Banking Authority (EBA).

As you can see in the world of bureaucracy it does not matter how poor your past history has been as the EBA finds that it still has a role in today’s procedure. In the world in which we now find ourselves bureaucracy is as all-pervasive as Japanese Knotweed.

How has it worked in practice?

Methodology
The comprehensive assessment is based on a capital benchmark of 8% Common Equity Tier 1, drawing on the definition of the Capital Requirements Directive IV/Capital Requirements Regulation, including transitional arrangements, for both the AQR and the baseline stress test scenario.

The stress test uses both a baseline and an adverse scenario for testing banks’ resilience to stress. In the baseline scenario, the EU economy develops in line with the European Commission’s projections up to 2016; in the adverse scenario, macroeconomic developments clearly deteriorate. The ECB collaborated closely with the EBA on the stress test methodology, and with the European Systemic Risk Board (ESRB), which drew up the adverse scenario. The baseline scenario was drawn up by the European Commission.

Comment

The essential issue here is the difference between the answer presented and reality. Rather than actually making European banks safe the actual purpose is to make it look as though they are safe. So a relatively small number of banks will be found to have a shortfall and procedures will then be put in place to fix that. However if there is a genuine shark in the water we are extremely unlikely to be told the truth and their lies the rub as Shakespeare would have put it.

Also any supposed cure comes with its own problems. The ECB wants banks to expand lending but now weaker banks will be told to raise their capital ratios which involves a combination of raising extra capital and reducing lending. Of course this is most likely to be taking place in the countries which are weakest and most need more rather than less bank lending. If we look at bank lending in the Euro area to businesses you can see what I mean.

The annual growth rate of loans to non-financial corporations was less negative at -2.2% in August, from -2.4% in the previous month (adjusted for loan sales
and securitisation, the rate was less negative at -2.0% in August, from -2.2% in the previous month).

In spite of extremely accomodative monetary policy supposed to boost such numbers the annual growth rate remains negative. There you have another example of the ECB finding itself between a rock and a hard place.

Let me add another factor as the benchmark consumer inflation rate used in these tests was 1.1%. Now if you consider what is a credible inflation rate forecast and the fact that it is clouded in mystery and uncertainty you see a challenge to the whole concept of a credible stress test.

I will be adding the results as they are released/develop. From the ECB

Capital shortfall of €25bn revealed at 25 euro area banks as of end 2013

12 of 25 banks already covered €15bn of shortfall in 2014; others have 2 weeks to prepare capital plans

Extra €136bn in non-performing exposures uncovered as part of exercise.

Oh and speaking of stress here is the ECB’s web page.

A problem occurred while trying to access this page

Number Crunching

This caught my eye.

Looks like Cyprus banking sector needs to raise over 10% of GDP in new capital

You see Cyprus found its level of GDP raised by 9.5% by the recent methodology changes ( ESA 10) and statistical improvements. So in with one hand and out with another!

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11 thoughts on “The ECB banking stress tests explained

  1. Hi Shaun, thanks for this on a Sunday!
    Certain things spring to mind, not least of which is the assumption of positive interest rates (at any level)…

    Do you think, even if these banks’ capital strength is sufficient to pass the tests, does it automatically mean they have enough liquidity to meet even modest calls?

    • Hi Andy

      I doubted I was able to stay away from it so it was better to sit down for a while and analyse it! As to your question the answer is yes for very small calls but these banks tend to go down for larger amounts don’t they?

  2. Pingback: Having read the ECB stress test, I am stressed | The Slog.

  3. Hi Shaun,

    A bonus post! Thanks; I was not expecting this today.

    I don’t think anyone feels reassured. The headline reads badly on face value, and anyone who digs a little deeper as you have done can see how lame this process is anyway.

    The evidence of a fundamental change in the prospects of western world just keeps mounting up but it just isn’t politically expedient to reveal the truth.

  4. Aren’t the stress tests just a PR exercise?
    Doesn’t the very fact of the need for them indicate problems?
    As you say, if the whole system is going mammaries skywards at any moment, they’re not going to tell us, are they?

    ZIRP is the one and only stress test I’ll believe.

    Don’t work too hard Shaun, have a day off during the week, you are a valuable source of knowledge to many of us; don’t burn yourself out.

    • Hi therrawbuzzin

      You are right to be asking such questions in my opinion. If things genuinely were okay then the stress tests would not be required.

      Thanks for the good wishes but I burnt out more energy watching the football later!

  5. Pingback: John Ward – Having Read The ECB Stress Test, I Am Stressed – 26 October 2014 | Lucas 2012 Infos

  6. Thanks for the additional post today Shaun. Much appreciated.

    The bit that confuses me is.. they know it’s a fabrication. Any trader can see its a fabrication. We all see that it’s a fabrication!

    .. so just who are they kidding and why does it still work even on the third attempt??

    • Hi Zak
      I think that many people like to believe those in authority. Also for those who are capable of critiquing this sort of thing many are seduced by the powers and benefits of official patronage. So those willing and able to speak out are a relatively small group.

      Accordingly these things gather their own momentum and continue. After all if proven ability and credibility were issues here the EBA would have been closed down.

  7. Shaun,
    Am I too cynical in believing the EC is sticking the boot in to the Italian banks after their PM pubished SGP demands against Commission wishes -if so await similar action on French reluctance to come to heel?

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