There are plenty of strange things about Europe’s banking stress tests. Notably, the idea of engaging in a test which is meant to assure nervous investors with its rigorousness — but not frighten them too much by actually finding big problems.
It’s Europe’s Goldilocks banking exercise. But more fantastical.
Anyway, earlier this week some details of the upcoming ‘stress tests v2.0′ were leaked to the Handelsblatt. The Wall Street Journal also has some numbers, but focuses on the use of local definitions of Tier 1 regulatory capital in the tests.
According to Handelsblatt, two scenarios will be applied by the newly-formed European Banking Authority (EBA) to the banks. Firstly a baseline scenario that reflects the European Commissions forecasts for growth and inflation. Secondly, a ‘stressed’ scenario that has eurozone growth falling 0.5 per cent in 2011 and 0.2 per cent in 2012. Property prices will fall too, but we don’t know by how much.
And then there are those haircuts. Handelsblatt says only bonds held in banks’ trading books will be marked down (yet again). German government bonds will get 3.5 per cent and French bonds 7.5 per cent. Haircuts for eurozone peripheral sovereign debt, meanwhile, will be as high as close to 20 per cent. The WSJ, however, reckons this year’s tests envision just a 17 per cent loss rate on Greek debt.
If that 17 per cent number is true, it means the EBA has totally lost its grip on reality is completely out of sync with market expectations. According to Handelsblatt, for instance, it’s also assuming an average increase in long-term eurozone bond yields by 75 basis points and 66bps for the European Union as a whole. The yield on Italy’s 10-year (which isn’t especially troubled eurozone debt) rose about 77bps over the course of 2010. It’s now at 5 per cent for the first time since 2008.
Gary Jenkins at Evolution Securities puts it well:
Scene: A dark room somewhere in Brussels. People in suits shuffle paper in front of them. A voice out of the dark is heard; “Right, we have to try and convince everyone that the European banking sector is in good shape so unfortunately we have to repeat the stress test exercise. After last year’s debacle when the Irish banks collapsed just after we had given them a clean bill of health this year we need to make sure that we have some sacrificial lambs, albeit ones that we know can remedy the situation pretty quickly. So the tests appear more credible but they don’t set off a panic…” Yes it’s that time of the year again and leaked documents regarding the European bank stress tests seem to show the stressed scenarios may be less stressed than those used for last year’s mainly due to a stronger economic outlook. It appears that sovereign haircuts will be higher for the likes of Portugal, Spanish, Irish, French and Italian government debt, but lower for German, UK and Greek debt. Wait a minute. Greek? Yes that’s right, whereas last year banks had to assume a 23% loss rate on holdings of Greek government debt, this year the loss rate will be set at 17%. I just hope that some of these leaks are incorrect or the people in suits sober up pretty quickly. Let’s put this into perspective for a minute; In the 3 months before the tests last year the average price of the Greek 10 year was close to 85. This year the average price has been 70. [An S&P analyst] stated that if it did default then investors may recover between 30-50%.
Jenkins might get his wish too.
Coincidentally (one assumes) the Committee of European Banking Supervisors’ attempted to go with that 17 per cent number in last year’s tests. The figure was criticised for being “the softest option possible,” and was eventually hiked to 23 per cent.
Official stress test details should be released on March 18.
Related links:
Concerns over latest EU bank stress tests - FT
A stress test mugged by reality – FT Alphaville
Building a better European stress test - FT Alphaville