Flannel and ostriches

Yesterday the European Banking Authority (EBA) published the results of its "stress tests" on European banks. The full report is here for those with time on their hands!

The "stress tests" were designed to test the ability of European banks to withstand economic problems such as recession. Losses arising from difficult economic conditions should be absorbed by shareholders' equity (common stock) and retained earnings - what is known as "Core Tier 1 capital" (see my blog explaining this, Reserve Confusion). 

Banks have historically held very little Core Tier 1 (CT1) capital, so in the financial crisis they had little ability to absorb losses, and taxpayers were forced to provide funds to many banks to prevent creditors (bond holders and retail depositors) losing their money.  Financial regulators around the world have since required banks to hold a higher percentage of risk capital, particularly CT1, against risk weighted assets. The European stress tests demonstrated that only 8 European banks have less than 5% CT1 against risk weighted assets and a further 16 have less than 6%.  Out of  90 banks tested, that isn't too bad, is it?

Actually it's flannel. The Basel committee recently recommended that internationally-active banks should have CT1 of 7% of risk weighted assets, and systemically-important banks should hold an additional 2.5%.  Now, not all of the banks tested are internationally active - the Spanish Cajas, for example, are domestic banks. But a lot are, and some are systemically important. So the EU test has actually set a low bar for CT1 and applied it equally to all banks, whatever their size and significance.  Reuters produced a useful little calculator yesterday which shows how many banks fail if the capital requirement is raised to higher levels. Apart from being great fun to play with, this calculator shows - worryingly - that if the EU had used the base Basel requirement of 7%, 41 banks would have failed. And at 8% 53 banks fail.  Highest on the list - i.e. needing to raise the most actual capital in monetary terms - are some banks that without question are systemically important, such as RBS, Deutsche Bank and Societe Generale. There isn't a snowball's chance in hell that they will meet the enhanced Basel requirement of 9.5% CT1 in any reasonable timeframe.

That's bad enough. But the EU test is also structurally inadequate. It ignores the biggest risk to European banks at the moment - the risk that there will be sovereign debt default in more than one country. Yes, the tests show that overall the European banking system can withstand Greek default, although Greek banks would fail.  But withstanding default by Ireland, Portugal and maybe Spain and Italy too - on only 6-7% CT1, which is what most EU banks have? I don't think so. 

Pity the EU taxpayers, especially German ones. The main thing the stress tests have proven is that if there is a string of defaults, they will have to stump up. And that will be inevitably followed by recession and austerity in the whole EU, not just the countries defaulting.

The structural inadequacy of the EU test, and the low capital requirement, arise from the fact that at the moment no EU leader is prepared to admit that multiple sovereign default is even a serious risk, let alone likely to happen soon.  I am reminded of the last line of Flanders & Swann's The Ostrich: "Here in this nuclear testing ground/ Is no place to bury your head!".  Let's hope the EU leaders get their heads out of the sand and come up with a sensible plan for dealing with excessive debt burdens in peripheral countries before the Eurozone blows up in their faces.


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