The Significance of the Bank Stress Tests in Europe

Douglas J. Elliott

The Europeans are conducting critical “stress tests” of the resilience of their banks in a potential severe economic crisis, with the results to be announced on July 23rd. This is somewhat similar to the U.S. stress tests that had such a positive effect on confidence in the American banking system and economy in the spring of 2009. There are a number of reasons to expect the stress tests to produce a less dramatically positive result than in the U.S., but they have substantially more chance of success than did the previous European stress tests, which were virtually ignored by the markets. On the flip side it is possible, although quite unlikely, that the stress tests will end up scaring the markets rather than reassuring them.

The three keys to success will be: an appropriate level of rigor; transparency on the process and results; and the assurance of a back-stop for those banks that need it. Insufficient rigor would destroy the credibility and usefulness of the tests while excessive rigor could cause panic about a quite improbable scenario. (In practice, there is little chance that regulators designed an excessively rigorous test.) Keeping important facts secret would sacrifice effectiveness, since the public is not in the mood to trust governments, in light of past assurances during the financial crisis that proved to be false or too optimistic. Finally, there are likely to be banks that will be shown to be weak. Governments must have a plan to shore them up, otherwise the tests could trigger a crisis rather than restore confidence. The highly successful U.S. tests met all three conditions, although there was some grumbling at the time that the tests were not sufficiently tough. In retrospect, the rigor seems to have been about right in total, even though some of the variables were set too optimistically when viewed individually.

What is the European bank stress test?

The Committee of European Banking Supervisors (CEBS), with technical assistance and counsel from the European Central Bank and the European Commission, is coordinating tests of the financial condition of major banks in various European countries. The tests are being run by the national banking supervisors in each country, but there is an attempt to apply a relatively uniform exam that still takes account of national differences. As stated by CEBS, the “objective of the extended stress test exercise is to assess the overall resilience of the EU banking sector and the banks’ ability to absorb further possible shocks on credit and market risks, including sovereign risks, and to assess the current dependence on public support measures.” Note that the tests are intended to determine whether the banks have the financial strength to withstand a significantly worse economic and market environment than the one currently expected. Each bank is being required to provide its best estimates of the effect on its own financial condition of the specific scenario the supervisors have designed.

Who is being tested?
91 banks, based in each of the European Union (EU) countries, are being included. The banks were included in order of size, from the largest on down, to ensure that at least 50% of each national market was represented. In total, they represent 65% of the EU banking market. This is similar to the U.S. approach, which tested the 19 largest banking groups in the country, comprising a roughly similar portion of the total banking market.

How severe is the scenario being tested?
CEBS states that the “scenarios include a set of key macro-economic variables (e.g. the evolution of GDP, of unemployment and of the consumer price index), differentiated for EU Member States, the rest of the EEA countries [the European Economic Area, a group of countries affiliated with the EU] and the US. The exercise also envisages adverse conditions in financial markets and a shock on interest rates to capture an increase in risk premia linked to a deterioration in the EU government bond markets.

On aggregate, the adverse scenario assumes a 3 percentage point deviation of GDP for the EU compared to the European Commission’s forecasts over the two-year time horizon. The sovereign risk shock in the EU represents a deterioration of market conditions as compared to the situation observed in early May 2010.”

The appropriateness of this scenario is in the eye of the beholder; essentially depending on assumptions about how tough a test of this nature should be and of how economies and markets would indeed perform in another crisis. Initial reactions of observers seem to be that the 3 point reduction in growth is reasonable, but that the haircut to the value of government bonds is too low. According to leaked information, the assumed losses on sovereign debt are 17% on Greek government bonds and 3% on Spanish government bonds. German government bonds are assumed to retain their full value. These losses appear to be closer to what the market already assumes, as opposed to where they would fall if things get worse.

We do not currently know what assumptions are being used for the unemployment rate, inflation rate, and other macro-economic variables. It is theoretically possible that the effects of a 3 point decline in growth have been mitigated by unrealistically small knock-on effects on other key variables. (Conceivably the opposite could be true, but it is much more likely that regulators would choose to soften the effects of the tests and thereby avoid more difficult political decisions.)

What results will be released from the stress tests?
We do not know what the regulators will choose to divulge. They have stressed a goal of “full transparency,” but we do not yet know what that will mean.

The release of quite detailed information was crucial to the success of the U.S. stress tests. The markets were given the ability to judge the relative rigor of the tests and to see how the results played out in detail for each of the 19 banking groups. As a result, the financial markets concluded that the tests were legitimate and that the banks really were sound, with the exception of GMAC Bank, which was already known to be in trouble. The detailed information strongly increased the confidence of the markets and led to a virtuous circle of greater confidence in the markets and in the economy which probably showed most clearly in the sharp and sustained rise in stock prices.

However, it is important to remember that U.S. regulators only agreed to provide this full level of detail after very considerable pressure from the markets and policy analysts. There were great fears among regulators about violating the usual practice of remaining silent about bank supervisory analyses. Regulators have learned over the years that releasing exam results or making statements that show a bank to be weak risks killing that bank by destroying public confidence. The situation during the financial crisis, and the situation in Europe now, represent rare circumstances in which the market already incorporates such a high level of fear that it is better to shine a light on the true situation.

What are the results likely to show?
In the case of the U.S. stress tests, there was enough external information available to make some reasonable rough guesses as to the results, although there clearly remained a fairly high level of uncertainty until the results were released (or at least foreshadowed by official statements shortly before the release).

It is more difficult to do this for the EU banks because they vary so much and because less information is available on some of them than is true of U.S. banks. Qualitatively, the following observations are likely to prove true:

The EU banking system will “pass” the tests. The EU regulators already know enough about their banks to design a test that they can collectively pass, in the sense that the large majority of banks will be shown to have enough capital or to need only modestly more. They already did a previous round of stress testing last year, although very little information was released about the results. In addition enhanced supervision was triggered by the financial crisis, ensuring that regulators know substantially more than they did a few years ago about the true state of their banks. If they are surprised in a major way, it will be evidence of a truly surprising level of incompetence. Assuming they do have a good feel for where things will come out, it is safe to assume that the test scenario was designed to produce broadly positive results. EU regulators had the political leeway to avoid these stress tests if they were too dangerous to run.

EU ministers and regulators are already foreshadowing positive results from the stress tests, lending further credence to this theory.

It is likely that some banks would need substantially more capital to handle the stress scenario. On the flip side, the markets will not believe a result that says all the banks are already in a strong position to deal with a scenario significantly worse than the expected case. There are doubts about some of the banks weathering even the expected case, much less a pessimistic one.

The relative strength of the EU banks is likely to vary considerably. The EU banking market is much more fragmented than the U.S. market. There are elements of Europe-wide banking, but it is still primarily a grouping of distinct national markets. This produces variations in three ways. First, the financial conditions of the banks vary because the economic health of the different nations in the EU differs very substantially. Second, national financial systems differ quite considerably in how they operate and in the relative importance of competitive sectors such as banks, insurers, and capital markets. Third, national regulation varies as well. For example, Spain, as is well-known, used counter-cyclical loan reserve requirements as a way to try to smooth out the banking cycles. There is also a range of regulatory trade-offs between safety and efficiency. The UK operated with a “light touch” regulatory system designed to enhance efficiency and competitiveness, while Germany and France had a considerably more active, even intrusive, regulatory presence.

How will the EU countries reassure the markets about the weaker banks?
This may be the most interesting question. The US was fortunate to have been able to run its stress tests at a point when it was still politically feasible to provide a capital backstop for the banks, if only because most of the $700 billion in funds authorized under the Troubled Asset Relief Program were still available. Public outrage against the banks makes it trickier at this point to step in to protect troubled banks.

That said, regulators and politicians across the EU are aware of the importance of having a backstop ready if the stress tests produce results that require it. Some nations, such as Spain, already have a backstop program in place to allow infusions of public capital in their banks. EU leaders were being quoted recently assuring the public that national backstop programs will be sufficient to handle any problems pointed out by the stress tests, but that access to the EU-wide stability fund would be available in the unlikely event it were necessary to tap it.

Will the EU stress tests be as successful as the American ones?
The American stress tests of last year were highly successful in restoring confidence in the banking sector. The EU tests are likely to be significantly positive in that regard as well, but probably not to the same extent as the American ones. Most basically, there is simply not the same degree of panic and therefore the alleviation of concerns will not produce the same dramatic improvements. In addition, there is no guarantee that EU and national authorities will reveal as much information to the markets or be as uniformly rigorous in their testing. Even if they are, it may be hard to prove to the markets, which would lead to a similar diminution of impact.

European financial markets have already risen significantly in anticipation of the positive results of the stress tests that are being foreshadowed by government officials. This certainly suggests that the net effect is likely to be a significant increase in confidence in the banking systems. Part of this, of course, may be the presumption that the stress tests will push national governments to insure additional private or public capital is infused into the banking system, which would clearly help stability.