Put Europe’s Banks to the Test

European banks must conduct stress tests to ease worry about the financial system. Pro or con?

Pro: A Survival Mechanism

It makes good sense for Europe to conduct a series of stress tests on its banks so that countries and companies have some better sense of their risk exposure.

Financial institutions use stress tests to determine the degree to which a bank or financial institution can withstand a shock of a given magnitude. For example, instead of doing a projection on a best-estimate basis, the bank does a scenario analysis looking at negative variables: What happens if interest rates rise to X percent? What happens if loan defaults rise to X percent? What happens if gasoline prices rise to $X?

But stress testing has relevance for other entities as well. One can apply stress tests to an entire nation. For example, what is the impact on the U.K. if the euro falls 25 percent? Or what happens to Germany if Greece defaults on its national debt? Stress testing also works with nonbank companies—say, a manufacturer or a retailer: What happens to Nestlé (NESN:VX) if the dollar rises and exports to the U.S. become more expensive?

The G-20 Financial Stability Board is urging European nations to publish the stress-testing results of its banks, and cites the openness of stress testing in the U.S. as a factor beneficial to restoring market confidence. Conservative or progressive, we can all agree that more stability in markets is a very good thing.

Con: Faulty Mechanics

Given the success of the bank stress tests run here in the U.S., should the same tests be administered in Europe as a precursor to economic recovery? Only if you believe in shell games, manipulating vigorous accounting principles, and the concept of "too big to fail." Aside from that, I believe our bank stress tests were largely a charade, and the same would likely transpire in Europe.

For any financial test to be deemed credible, the test itself needs to be truly robust. Those in America may claim our bank stress tests were truly successful, but I firmly believe the tests should be graded incomplete at best.

Why do I make this claim? Let’s enter the world of HELOCs (home equity lines of credit). The base-case assumption used in our bank stress tests was for cumulative losses on this product of 6 percent to 8 percent with a worst-case scenario of 8 percent to 11 percent. Those assumptions were ridiculously low. Our banking system continues to be chock-full of likely hundreds of billions in losses on this product. Those losses were largely overlooked in our tests.

Would European bank stress tests fully expose the nature and value of a variety of loans held on their books or merely disguise them in the same manner as the U.S. tests? If European governments want to play that game, then they should go right ahead and run the same tests and play the same charade, but do not expect real transparency and integrity along with them.

Opinions and conclusions expressed in the Bloomberg BusinessWeek Debate Room do not necessarily reflect the views of Bloomberg BusinessWeek, BusinessWeek.com, or Bloomberg LP.

Reader Comments

coe

There is no doubt in my mind that the stress tests in the US provided some optical comfort, but that the assumptions that drove the numbers were flawed and didn’t capture the risks with anything remotely approaching "market” accuracy. I'm also of the distinct (and validated) impression that individual banks “worked" the numbers with the regulators as the tests were conducted--a little bit like a college student helping his professor grade his own essay. That said, if the formulaic approach was reasonably consistence across all banks, then we would get valid relative results. Is anyone surprised that part of the objective was to use these soft forensics to engender confidence in the banks and financial system at a time when more bad news could have proved to be the tipping point? I expect the same from the exercise in Spain and presumably the Euro zone as a whole. You speak to the implications in your column on investing in China--questionable accounting combined with regulatory policy intrusion/inconsistencies and politics equal valuation uncertainty for investors. The plain unvarnished truth is that virtually all banks have material unrecognized "mark-to-market" exposures that they are dancing around. If asymmetrically in an accounting sense (i.e. asset transparency with no corresponding offset for liability duration) a gun was put to the head of the global banks and they actually marked these assets to current liquidation pricing, the capital accounts, already in precarious shape, would be woefully short of regulatory requirements. Oh, but then select big banks could pull out their "get out of jail free" too-big-to-fail free pass, while many regional and community banks would find police tape around their buildings on any given Friday and swell the footings of the FDIC resolution tables. There is no real debate--kabuki theater is an acquired taste and not for everyone. As Harrison Ford, playing everyman hero Jack Ryan said when asked by the President to do the 'ol Potomac two-step in "Clear and Present Danger," he responded, "I'm sorry Mr. President, I don’t dance"--a mark to market moment in cinema. Well, if we are not facing 'clear and present danger' now on many of these fronts we never will be. Avoid the two-step, LD, and, never ever consider doing the lambada with the policymakers.

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