With certain banks in the core eurozone states initially passing the European Banking Authority's generic stress-tests but then needing to be saved, surely now is the time to apply more rigorous testing procedures much like those endured by banks in the eurozone periphery countries?

Stress-tests have moved centre stage and are now a major driver of sentiment about banks and sovereigns. The annual Europe-wide stress-tests for banks continue to create a raft of headlines and column inches every July. While receiving less global attention, the tests taking place on an individual country basis, such as those in Ireland, Portugal and Greece, are perhaps more significant.

The tests on banks in the eurozone periphery countries are in fact much more stringent than the generic annual tests that are run by the European Banking Authority (EBA). If these same rigorous single-country tests were applied to banks in the core eurozone states of Germany, France, Spain and Italy, they would almost certainly reveal markedly higher losses on balance sheets than the EBA tests. The truth is that countries need to own the regulation of their individual banking systems while operating within a common European framework.

Credibility crisis

The EBA by its nature has to cover a wide variety of markets in its annual tests. It has to make macro assumptions by trying to provide points of comparison between banks and countries. As a result, the Europe-wide tests have suffered from credibility issues. It is frankly impossible to overlook the fact that certain banks that passed the tests have subsequently had to be saved. 

In July 2011, the tests did not include any haircuts for sovereign debt – this was completely undermined by the market which was pricing in risk for Greece. Shortly afterwards, a supplementary exercise had to be run to identify 'temporary' capital buffers required to reflect current sovereign market prices.

While much blame has been laid at the door of the EBA, the authority is undoubtedly hamstrung by its political masters. Throughout Europe there is a need to think through the mandates for the vital European institutions, including the European Central Bank (ECB), the European Financial Stability Facility and the EBA. Without clarity on their precise mandates and greater independence from political pressure, these bodies will continue to be limited in what they can do to resolve Europe’s financial issues. Even with a clearer mandate, the European stress-tests should only be seen as a minimum standard providing a common baseline across Europe.

Systematic approach

Undoubtedly, some European countries take stress-testing more seriously than others. Where the so-called troika – the EU, the International Monetary Fund and the ECB – has provided financial assistance, it has been a condition that there should be a stress-test of the banking system using an independent third party. In Ireland, the stress-tests identified a capital shortfall of €24bn based on a severe macroeconomic scenario, conservative modelling assumptions and higher Tier 1 requirements than the generic EBA requirements. These stress-tests, while identifying large losses, were helpful in rebuilding international confidence in Ireland.

Tests are being run in Greece and Portugal and it seems likely that further capital shortfalls will be identified. However, this higher standard is not being applied equally and the lack of certainty about the quality of bank balance sheets within the core of the euro area has been a contributing factor to the new credit crunch.

Stress-tests involve complicated calculations about the potential losses on banks’ balance sheets in extreme but credible scenarios. The challenge is how to make the approach and calculations more transparent and not part of some ‘black box’. Whatever the approach, there are a number of challenges that stress-tests continue to face. These will ultimately impact on their future success.

Wholesale market dependence

Government debt levels are expected to increase in the coming years – this means that sovereigns are under significant pressure to demonstrate that they can pay their way. As Greece has shown, if the sovereign loses credibility, it can bring the country’s banks down with it, and so sovereign risk becomes bank risk. There is also too heavy a reliance on wholesale markets – the EBA found that 42% of bank funding came from wholesale and interbank sources, rather than less risky consumer deposits. If markets freeze up, banks will not have any access to funding.

Unfortunately there is no easy solution – stress-tests have become a key part of the toolkit in dealing with the reshaping of banks. However, they need to be carefully calibrated to be credible while not undermining the banking system as a whole. There has been a lot of angst as to whether the central issue has been one of liquidity or capital. In truth it has been both, with a negative feedback loop operating between them. If banks require more capital, then stress-tests can provide the basis for a recapitalisation and restructuring programme – a first step in rebuilding confidence.

Nils Melngailis is a managing director and Ajay Rawal is a senior director in the financial services team at global professional services firm Alvarez & Marsal.

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