Economists React: European Stress Tests Leave Unanswered Questions

VIANDRAMINERVA–The tests’ credibility can be questioned in at least four ways. First, they failed to include a scenario involving a sovereign debt default. Second, the assets tested involved only sovereign bonds traded, not those held to maturity by banks. Third, the bar for passing the tests was set low, at a minimum 6% capital-to-asset ratio. Fourth, the tests measured banks’ asset quality but not liquidity. Many banks that passed, such as those in Greece, rely heavily on the ECB for liquidity. – Zach Witton, Moody’s Economy.com

–Why was it that national agencies were allowed to determine what might happen to house prices, so the Greek worst case scenario was for only a 2% decline in property prices? Why was the shock assumed to be global, rather than local, including a much higher spike in funding costs in the periphery markets? Why did the worst case assume a smaller gearing of unemployment to GDP than seen historically? Our list could go on. The important thing now is that with the detail provided greater than expected we can tick this box and move on. Ultimately, so much depends on there being a relatively strong recovery, which in our view still requires a weaker euro. –David Owen, Jefferies International Ltd.

–While the initial reaction to the news that only the trading books were stressed for sovereign exposure appears to have been negative, we think that market sentiment on this issue is likely to improve for two reasons: (a) extent of disclosure and (b) magnitude of impact. With around 90% of the banks providing details on their sovereign exposure (notable exception being some of the German banks), we think investors have sufficient information to model their own scenarios and assess the impact on banks’ capital… We have previously highlighted the fact that European banks’ exposure to peripheral sovereigns may be more limited than thought by the market and that the “real” risks to banks is likely to come from fiscal consolidation and austerity measures and the impact they could have on economic growth and asset quality. We think that the recent disclosure continues to support this view. –Nomura Credit

–The credibility of the stress tests has been weakened by (i) the exclusion of sovereign exposures outside the trading book from the stress test, (ii) the use of a Tier 1 capital ratio target as opposed to core Tier 1, (iii) allowing banks to exhaust all cumulative provision loss reserves in the stress scenario and (iv) crediting banks with tax loss generated from the stress test, even though these can only be applied against future years of profitability. The results of the stress test might reassure investors about the health of large quoted banks, but they are unlikely to restore confidence in the smaller periphery banks: 34 out of the 40 least capitalised banks in the stress test are in the periphery (periphery stands for Italy, Spain, Portugal, Greece and Ireland). –RBS European Economics

–The question traders and investors wanted answered by the bank stress tests was this: If Greece, Portugal, Spain, Italy or Ireland default on their bonds — or if prices on those bonds are marked down by 20% or more in a restructuring scenario — do European banks have sufficient capital to withstand the shock? The EU, the ECB and the CEBR did not answer that question in any way, shape or form. –Carl Weinberg, High Frequency Economics

–For the European tests, greater transparency is certainly the most significant accomplishment. The participating banks have been required to disclose details about their holdings of government debt for 30 different countries on both their trading and loan books. Given that one of the greatest complaints by investors had been the lack of information about these holdings, such disclosure is a major step forward… The stress test did not fully address the biggest concern among market participants: a sovereign default or restructuring. However, the combination of the detailed bank-by-bank debt exposure and the sizable — and untapped — bail-out fund could go a long way toward damping market concerns. More broadly, recent positive growth data should assuage concerns about other loan losses. The exercise itself may not have been particularly informative, but the information revealed may significantly impact sentiment. Here is a case where honesty really is the best policy. –Michael Hanson and Ethan Harris, Bank of America Merrill Lynch

–While the testing has disappointed, the extra transparency is to be welcomed. Despite its shortcomings, this is a progressive step towards reducing systemic risk and improving the stability of EU banking but immediately raises more questions than provides answers. I’d now urge the EU and Committee of European Banking Supervisors (CEBS) to actively engage with the market to address questions emanating from these tests and to enhance the stress test already done to capture a “worst case” scenario. This would help bridge the gap of skeptism between the regulators and the ultimate providers of essential capital, the market. –Gerard Fitzpatrick, Russell Investments

–The methodology underlying the stressful scenarios actually turned out to be slightly more severe than we and others had expected. And yet, the outcome was still to give an apparent clean bill of health to 84 of the 91 banks tested.. For now, we stand by our view that these stress tests have still been worth doing even if the results, on the face of it, have the look of a whitewash. –Peter Westaway, Nomura Global Economics

–Looking at the change in Tier 1 capital ratios between the reported 2009 and the 2011 stressed result, the best performing big banks are from the UK, Spain and the Nordic region. Barclays leads the large caps, with Santander and BBVA high up in the table. Nordea, Intesa, Lloyds and BNP Paribas round out the large caps in the top quartile. If we use absolute stressed Tier 1 levels, the UK and Nordic banks again feature at the top of the table. And French are best of the Euro area. –Citigroup Global Markets

–Despite imperfections, some generous interpretations and missed opportunities, they should help in reducing tail risks on the Spanish sovereign, reduce uncertainty and help support the stronger European banks’ funding and valuation. Sovereign exposures disclosure and credible Spanish stresses are the factors supporting this. However, it is less clear to us that there will be a step change in funding costs for some of the mid-tier banks, where quality of capital issues have not been addressed in earnest. We think medium-term deleveraging will still be a concern reinforcing a creditless recovery for some Eurozone countries’ growth and require ECB/other policy support… We feel the European banking sector has been pivoting in part around expectations on the Spanish sovereign. We would be overweight banks including BNP, Soc Gen, CSG, Barclays, UBS & Baer. –Morgan Stanley Research Europe

–We think the tests should have been tougher, and we feel the whole exercise lacks credibility. We don’t see the Tests as a strong positive catalyst for equity investors, although we do expect them to help in the gradual normalisation process of funding markets. –Arturo De Frias Marques, Evolution Securities

–Rather than a game-changer, the release of the stress test results is a first step towards improved transparency, but insufficient to bring about the rapid and major improvement in confidence in the European banking system which should have been the main goal of the exercise. It will require more homework by both market participants and policymakers to move towards full normalization of the eurozone financial system—in particular it will take some time to process all the information made available by national regulators and by the Committee of European Banking Supervisors. The overall results confirm our view that the bulk of the eurozone banking system is sound, but there are serious questions on whether the tests can be considered sufficiently stringent and informative. –Marco Annunziata, UniCredit Group

–After the relief passed, cynicism crept in. After all, 10 banks had widely been thought to fail — not just seven. And the consensus was for 30 billion euros to be required to shore up finances — not just 3 billion euros. Apparently, that the tests failed to include sovereign bonds held in the “banking side” of balance sheets, which is where 90% of the bonds are held, allowed for the better than expected test results. And some in the market are already looking the next hurdle for European banks: the re-financing funding that will be required for banks to be able to fund business clients’ requirements in coming years. –TJ Marta, Marta on the Markets

–The results, combined with the ongoing government/official support of the banking sector has, to at least some extent, left the market satisfied with the state of affairs in the banking sector. That said, there are enough open questions regarding the credibility of the stress-tests to leave us apprehensive that the market’s reaction was more a reflection of the relative unimportance of the measure to the broader economic landscape. –David Ader, CRT Capital Group