Despite Headlines, it’s Good News on Europe’s Banks, but with Some Risk for the ECB

European banks are in much better shape than many had feared, if the results announced yesterday for the combined “asset quality review” and “stress tests” are accurate measures of the underlying situation and future prospects for the banks. I know the key people involved and they are highly professional and had a strong incentive not to be too lenient, so I tend to take these results as truly positive. They had political room to produce somewhat more pessimistic results, so I interpret these optimistic findings as their true beliefs. On the downside, the European Central Bank (ECB) now “owns” any major banking problems in Europe and runs real risks if these tests were in fact too optimistic, or even if they were broadly right but new problems develop. Observers generally will not distinguish after the fact between new problems and the playing out of old weaknesses. It is hard to read these results as excessively harsh, which would have been the only protection for the ECB.

What was so good about the results? Only 10 percent or 13 banks out of 130 need to raise any additional capital and the total requirement is a miniscule 10 billion euros compared to 22 trillion euros of assets owned by these banks. This not only says positive things about the current state of the banking system, but also removes the threat of regulatory pressure to deleverage further, which might have inhibited needed lending.

Previous estimates of capital needs have ranged upwards from about 50 billion euros to many hundreds of billions, although the latter tended to be based on very broad, and rather pessimistic, assumptions. In truth, the results are a bit above the lower end of the private estimates because the final numbers reflect considerable capital raising taken by banks in anticipation of these tests. If you add the 57 billion euros of equity raising in 2014, and other actions taken to reduce capital needs, then the results come into line with a number of earlier private estimates.

Overall, one has to be very pleased with these results, unless one doubts the methodology. There are three broad strands of attack. One is that political and institutional pressures, such as “regulatory capture” by the banks or excessive reliance on national bank supervisors, makes the figures unbelievable. Another points to earlier alternative estimates, such as those by Viral Acharya and co-authors, that were much bigger. The third set gets more into the details and disputes important methodological choices. Sovereign debt is assumed to be fully repaid; the stress tests do not include a deflation scenario; parts of the banking system that were not included in the tests are argued to be severely troubled; et cetera.

There is a strong likelihood that the system’s capital needs are somewhat higher than shown here because of some of the exclusions from the analysis. However, I tend to believe that the ECB, and the European Banking Authority (EBA) with which it cooperated, got this largely right. The ECB is taking over as the Single Supervisor for the new European Banking Union and is well aware that this is its one chance to start with a clean slate. Any problems identified in the tests belong to previous supervisors; anything not identified upfront will be blamed on the ECB in the future. There were political pressures on the ECB to be lenient, but by far the greatest pressure was for them to be tough to protect themselves. I know the senior people involved and have spent considerable time talking with them about the process. They are smart, expert, tough-minded, and well aware that their interests lay in rigor, not leniency.

So, I am pleased by the results, but well aware that the ECB is now at risk. If the findings are fundamentally right, it will be the best of both worlds, with a relatively benign banking situation and growing credibility for the ECB. If the examiners missed some significant problems, then it will be the worst of both worlds, with a banking system whose ills spill into the real economy and an ECB that has been wounded by its mis-estimates. My money is on the ECB, but it is impossible to be certain. They could have been operating with the wrong conceptual framework and, as a result, missed important risks and problems. “Asset quality” is about the likelihood and size of future repayments from a loan or other asset, and therefore something of a prediction of the future. And, as all of us know, predictions are fallible.

The US stress tests of 2009 are a hopeful precedent. They came in considerably more optimistic than the market had expected and there were many criticisms of the assumptions, but the authorities turned out to be fundamentally right. Sometimes the people in charge do know what they are doing.