Stress Tests Will Only Draw Out Financial Crisis: Danny Gabay
The first step toward a solution is to recognize that you have lost control of the problem, according to Alcoholics Anonymous. In that spirit, the Committee of European Banking Supervisors’ report on bank stresses is welcome. But as attempts at clearing the air go, the exercise is a failure and will go down as a missed opportunity.
The committee said the overall objective was to assess “the resilience of the EU banking system to possible adverse economic developments and to assess the ability of banks in the exercise to absorb possible shocks on credit and market risks, including sovereign risks.”
But wading through the 55-page report reminded me of being a small child at a family gathering at which your “funny” uncle attempts to convince you that he can make a coin disappear by clumsily passing it from one hand to the other. In this case, it is bad debt that is passed between banks and sovereigns. Hence the attempt to argue that Europe’s banks are largely safe as long as there isn’t a sovereign default makes as much sense as saying a watch is waterproof as long as it doesn’t get wet.
In reality, a sovereign default and a banking crisis represent two sides of the same coin -- namely an excess level of debt in the system. Financial risk might, like energy, be subject to the laws of physics -- that is to say, in a closed system, total energy (or risk) is a constant. Or put another way, financial risk can’t be destroyed by simply moving it from one balance sheet to another.
Latest Staging Post
The underlying crisis remains the same. It is still all about the solvency of the banking system, and it remains unresolved. As the Bank of England says in its latest Financial Stability Report, “the interconnectedness of the financial system amplifies the credit risk faced by individual banking systems.” Europe is merely the latest, though not necessarily the last, staging post.
By the same token, the idea that the European Financial Stability Facility and the European Central Bank’s U-turn on direct purchases of government bonds was anything other than a bank bailout is much mistaken. The EFSF is merely the latest in a line of state-financed bank bailouts. The question is, will it be enough?
On July 23, the same day that the Committee of European Banking Supervisors published its report, seven U.S. banks failed, bringing the total that have gone under since 2008 to about 250. America has many more small banks than Europe, but the failure rate is still lopsided.
Greek Default
Based on credit-default-swap pricing, it seems that investors see a better-than-even chance that Greece will either default on its debts, or leave the euro, or do both. But the CEBS test was based on a 5 percent probability, and even then only on some sovereign-debt risks.
The good news is that all forms of credit by euro-area banks to governments amount to about 130 percent of capital and reserves. Fortunately, the public debt of the three countries most at risk -- Greece, Portugal and Spain -- equals only about 14 percent of all public debt in the region, according to economists Daniel Gros and Thomas Mayer.
The overall exposure of euro-area banks to the public sector in the three countries most likely to come under speculative attack is large in absolute terms, about 400 billion euros ($523 billion), but even a 50 percent loss would amount to less than 10 percent of aggregate capital and reserves of the banks, Gros and Mayer said in a report in May.
Lot of Debt
The bad news is that euro-area lenders still have an awful lot of debt to roll over in the next three years. International Monetary Fund data suggest that commercial euro-area banks may need to roll over more than 2 trillion euros of debt by the end of 2013. And the biggest failing of the stress test is that it has not really helped investors to distinguish between good and bad banks in relation to that threat.
According to the Bank for International Settlements, French and German banks are particularly exposed to the sovereign debt of some peripheral euro-area countries. At the end of 2009, they had $958 billion of combined loans ($493 billion and $465 billion, respectively) to the residents of these nations. This amounted to 61 percent of all reported euro-area bank loans to those economies.
The Bank of England says U.K.-owned banks are particularly exposed to the French and German banking systems, which account for about a quarter of their claims on banks globally. We really are all in it together.
In the end, the financial crisis will be resolved when either asset prices recover fully and/or bad debts are properly written off. Past experience suggests this process will be long and drawn out, though hopefully not as long as it has been in Japan. In the meantime, investors are left to rely on their own wits to decide which banking systems and banks are the safest.
But if we have learned anything since 2008, it is that when investors know there is a debt load, but not precisely who owns it, all banks quickly come to be seen as part of the problem. The sooner Europe realizes this, the safer we will all be.
(Danny Gabay is a director at Fathom Consulting, an independent macroeconomic and financial-markets consulting firm in London. The opinions expressed are his own.)
To contact the writer of this column: Danny Gabay at danny.gabay@fathom-consulting.com
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