DON´T FLUNK THIS ONE / THE ECONOMIST ( VERY HIGHLY RECOMMENDED READING )

European banks

Don't flunk this one

The stress tests of Europe’s banks have been chaotic. But it is too soon to write them off

Jul 15th 2010


WHEN America did public stress tests on its banks in 2009 they helped end the panic on Wall Street. The Federal Reserve opened banks’ books, imposed a consistent view about how bad losses might be and forced banks that lacked capital to raise more, with the taxpayer acting as a backstop investor.

Europe will soon follow suit, with the results due on July 23rd. Yet whereas America’s tests were run in military style, Europe’s efforts have been chaotic—more akin to a rowdy negotiation about cod quotas than the recapitalisation of the world’s biggest banking system. With just days to go regulators must redouble their efforts to make the tests work.

Stress tests are certainly needed. Banks and transparency are not always a good combination. When a carmaker admits it has a hole in its balance-sheet, its factories are still there a week later; when a bank does so it usually suffers a devastating run. This is why regulators sometimes like to deal with dud banks in secret. But when there is already a widespread loss of confidence, sunlight is the only treatment left. That happened in Japan in 2002-03, when zombie banks were at last prodded to own up to their bad debts, and in America last year.

Europe has reached a similar point. Some banks have been locked out of international borrowing markets, reflecting worries that they could be brought down by the woes of southern Europe and the suspicion that they are sitting on sour loans from the boom years. The fear of contagion has raised debt costs for other banks. Unless faith is restored, the continent’s banking system, heavily reliant on wholesale borrowing, faces a funding crunch. That would force banks to lean even more heavily on central banks and governments to roll over their debts. It could also bring on a double-dip recession.

Full marks aren’t good enough

The task is huge. Europe’s banking system is far bigger than America’s: 91 banks are being tested, compared with 19 on Wall Street. Politics has made things harder. Lacking a single body with the authority and resources of the Fed, the tests are being run by a tangle of national regulators, the European Commission, the European Central Bank and a quango called the Committee of European Banking Supervisors.

Consistency and credibility seem to have been sacrificed. Germany’s banks, which are in poor shape but which can continue to borrow cheaply because they have the backing of a government with strong finances, have given the nod that they expect to pass. The tests may fudge the issue of sovereign defaults by assuming haircuts on assets held in trading books, and not on loans. And unlike America, Europe seems keen to use a lax definition of capital that is no longer viewed by the market as the best benchmark for solvency.

It’s too late to remedy all of these faults. Yet it is also too soon to write off the tests, which are still being finalised. For them to work, three things need to happen. First, some banks need to fail—the only thing a 100% pass rate would prove is that the questions asked were not hard enough. Encouragingly, some firms say the tests have been tightened at the last minute.

Second, even if fully factoring in the risk of sovereign defaults is politically impossible, the issue needs to be dealt with convincingly. Each bank’s exposures to vulnerable economies should be disclosed in detail. As was the case with subprime debt, it seems likely some banks are underreporting their risks. Tough tests in Spain, the big economy that investors worry about most, are also critical for credibility. It has lowish public debt but some fear it cannot afford to bail out its crippled savings banks. That concern looks overblown and in any case Spain could tap Europe’s new bail-out fund. But its regulators and politicians must now back up their hard talk with action—even if other countries treat their banks more leniently.

Finally the stress tests must be stage-managed competently. America’s tests were rigorous but also a dazzling display of regulatory skill. The last thing Europe needs is the chaotic release of results for 91 banks, with national regulators privately disowning the conclusions and no plan for recapitalising firms that fail the exam. The worst case is not that the tests are merely irrelevant, but that they actively damage confidence. Europe can surely do a lot better than that.