The hype preceding and following the stress test exercise conducted by the Committee of European Banking Supervisors was inevitable. Markets have been jittery for the past two years. The fear that a major European bank may go under was always at the back of the mind of many professional and private investors.
The results of the test were predicted long before the actual tests were conducted under the supervision of local regulatory authorities. The scope of these tests was partly to reassure the markets that European banks were indeed sound. It was important that the great majority of banks passed the test, but it was equally important that a few failed in order to give credibility to the exercise.
In the end the results that many financial journalists forecast quite accurately when the tests started, contained no surprises. Ninety two per cent of the banks tested passed the test.
The seven banks that failed were five small state owned Spanish savings banks together with a relatively small German property bank that has long had capital problems, and a Greek agricultural bank. So everyone should have been happy with these results. Not quite!
The business media immediately labelled the stress tests as not being stressful enough. Gillian Tett, US Editor of the Financial Times, stated that the European stress test “was neither uniform, nor transparent nor stressful enough”. For instance, it was assumed that no eurozone country would default – an assumption that some analysts now consider as rather imprudent. In a video clip on ft.com Ms Tett described this exercise as a “whitewash”, even if she was much less dismissive of its validity than some other financial journalists.
Reuters quoted Eric Fine, portfolio manager of Van Eck Global’s G175 Strategies, as saying that he did not believe the tests were very credible as they did not focus on entire balance sheets. “The evaluations took into account potential losses only on government bonds the banks trade, rather that those they are holding to maturity.”
Richard Cranfield, chairman of the global group Allen & Overy, the law firm, is quoted by the Financial Times as saying: “Arguably the failure here is not the banks concerned but the test itself. There is little evidence that the tests have been applied consistently and there is a distinct lack of credibility making this a wasted opportunity.”
I do not agree with this downbeat assessment. Surely a partially valid stress test is better than no stress test at all. Hopefully, lessons will be learnt from this exercise. Whether fund managers will be convinced to hold more bank debt and equity as a result of this test remains to be seen. Asian sovereign wealth funds are reported to be still very cautious about holding such debt. The same attitude is being adopted by the major US fund management companies.
The shortfall of €3.5 billion in the capital of the seven banks that failed the test can be found in a very short time to enable these banks to hit the six per cent Tier 1 capital ratio. But the real challenge for all the 91 banks subjected to the test is to convince the markets that they are indeed sound, not just because they have sufficient capital, but because they are managed by capable people who really act in the interest of all the stakeholders.
What caused the near collapse of the financial system in 2008 was not so much the banks’ lack of capital, but the ethos of greed that permeated the board rooms of many banks and made them take risks they were incapable of managing. Behavioural finance can tell investors as much as capital ratios about which banks are courting trouble because of cronyism, too much focus on short-term profit objectives, and other flawed management behaviour.
Some time ago I discussed the relevance of medical stress tests with a friend who is a doctor. I was surprised with his unenthusiastic comment that medical stress tests do not tell you much more than you already know as a result of a thorough check-up. He added: “Since I have seen a middle aged patient die from a heart attack just three months after passing a stress test with flying colours, I have learned to look for health risks far beyond the areas covered by structured stress tests.”
Banks stress tests have to be viewed with the same clinical detachment.
jcassarwhite@yahoo.com