Peaking over the horizon this Tuesday — some more European banking stress tests.
Via Reuters:
Dec 7 (Reuters) – The European Union will begin a new round of tougher stress tests for banks in February as part of its response to dealing with the debt crisis, EU Economics and Monetary Affairs Commissioner Olli Rehn said on Tuesday.
“One of the elements is the preparation of a new round of even more rigorous and even more comprehensive bank stress tests which will start from February next year and will be based on new financial architecture,” Rehn told a news conference after talks with EU finance ministers and other officials on Tuesday.
“New financial architecture?” You’ve got our attention Mr Rehn.
This summer’s European stress tests, you’ll remember, were rather deeply and ruinously flawed. 84 of the 91 banks tested passed — including the likes of Allied Irish. Another round would mean a second chance for European ministers to really convince markets they have a grip on the health of Europe’s banking system.
Off the top of our heads then here are some suggestions for round II (ding, ding) :
1) Don’t tell banks what they’re being judged on. This summer’s focus on Tier 1 capital ratios was advertised well in advance, which means financial institutions knew exactly which figure to manipulate seek to improve. (An easy way of doing this would have been by temporarily decreasing loans and building-up cash).
2) Haircut held-to-maturity (HTM) assets as well as those available-for-sale (AFS). Administrators only stress-tested assets in banks’ AFS books, while HTM ones were exempted. A quick reclassification of sovereign exposures would have been all that was needed to help help some banks significantly game the stress tests.
3) Consider focusing on Tier 1 equity capital. Don’t take into account hybrid capital. This, the market knows by now, is iffy and likely to be ‘burdenshared’ should a bank enter into serious difficulty. It also is typically the stuff handed out to banks as part of government support packages, which leads us into …
4) … The big one. For financial stability’s sake, figure out a way to strip out sovereign support, or at least discriminate between states. The last stress tests, despite being sparked by sovereign worries, inexplicably ended up including sovereign support (like government guarantees) in their assessment of banks’ capital health — and without differentiating between them either. In fact, government support measures added anywhere between 0.1 and 11.1 percentage points to banks’ stressed Tier 1 ratios in the exercise. So find some method of illustrating the added risk which some government bonds now pose — variated risk-weightings or whatever. This is anathema to the way regulatory capital has worked in the past, but it’s clear that the market is now focused on bond exposure, so stress tests should be too, assuming the CEBS wants to reflect real concerns.
That is of course, a big assumption.
Implementing all or any of the above could end up with less than that 92 per cent pass rate, which could send markets panicking. Still though, there’s an argument to be made here for brutal honesty (and pessimism) followed by swift recapitalisation.
We’re not holding our breath though.
Related links:
Stress tests sovereign support = senseless – FT Alphaville
Gaming the stress tests 101 - FT Alphaville
A test cynically calibrated to fix the result - Wolfgang Münchau