In the five months after the U.S. published results of its 2009 bank stress tests, the Standard & Poor’s 500 Financials Index rose 25 percent. Five months after the European Union released its version, the Bloomberg Europe Banks and Financial Services Index is down 4 percent.
The failure of the EU tests to restore confidence in the region’s banks was underscored last month when Ireland directed its two biggest lenders, both of which passed the exams, to raise additional capital. Since the results were disclosed on July 23, the cost of insuring the senior debt of 110 European banks against default rose 113 basis points, or 1.13 percentage points, while credit-default swaps on 34 of the largest U.S. banks are unchanged, according to data compiled by Bloomberg.
Now, amid a widening European debt crisis, regulators from 27 nations are searching for ways to improve the tests, which will be repeated next year. That won’t be easy as long as national leaders and central banks remain unwilling to cede bank oversight to a central authority, said Nicolas Veron, a senior fellow at Bruegel, a Brussels-based economics research group.
“Financial nationalism prevented the tests from being credible or really useful,” said Veron, who’s also a visiting fellow at the Washington-based Peterson Institute for International Economics. “Nations view the bank tests as a competitive game among countries and not as a way to ensure the common good of European financial stability.”
To be more credible, the next bank tests need to take into account the risk of sovereign default -- something not all nations may be willing to do, according to Peter Hahn, a former Citigroup Inc. banker who lectures on finance at Cass Business School in London. With European lenders holding 191 billion euros ($255 billion) of Greek, Irish and Portuguese debt, according to Goldman Sachs Group Inc., any restructuring of national debt could force banks to raise more capital.
“The concept of European government default and the potential inability to backstop banks are the key issues for the markets,” Hahn said in an interview. “Today, very few people have much confidence in their bank. Confidence is in the nation that backs up your bank, not in your bank.”
The Markit iTraxx Financial Index of credit-default swaps linked to the senior debt of 25 banks and insurers rose 4 basis points to 151 basis points today, and a similar index linked to subordinated debt climbed 12.5 basis points to 302.5 basis points, a sign that perceptions of credit quality are worsening.
Swaps on UniCredit SpA, Italy’s biggest bank, rose 24 basis points to 383, while those on Royal Bank of Scotland Group Plc jumped 9 basis points to 190, according to data provider CMA.
Investors have less confidence in European banks than in their U.S. competitors. The price-to-book ratio of the 50 largest European banks is 0.76, compared with 0.97 for the top 50 U.S. banks, Bloomberg data show. That means the market value of European lenders is on average only 76 percent of the value of their assets, suggesting investors don’t believe banks’ assets are worth what they say they are. In 2007, the ratios for European and U.S. banks were 2.15 and 2.14.
Using stress tests to calm markets is “an abuse of the technique,” said Simon Gleeson, a financial regulatory lawyer at Clifford Chance LLP in London.
“Stress tests are a useful tool if they are used by people who know how to interpret the data well,” Gleeson said. “Properly conducted stress tests require a wide variety of scenarios and possible outcomes with no simple answers.”
The European Central Bank -- the regional counterpart of the U.S. Federal Reserve -- isn’t responsible for bank supervision. Instead, the exams were coordinated by the Committee of European Banking Supervisors, a London-based forum for national regulators that will be renamed the European Banking Authority Jan. 1.
‘Very Small Operation’
Even with its new name, the group won’t have enough power to conduct a successful test next time, Hahn said. CEBS has about 30 employees compared with about 3,300 at the Financial Services Authority, the U.K. regulator.
“It’s a very big task for a very small operation,” he said. “It will depend on what banks provide and what their countries’ politicians or regulators want them to provide.”
Franca Rosa Congiu, a spokeswoman for CEBS, declined to comment.
European institutions have been forced to play a greater role in solving the region’s financial crisis, with the EU and the International Monetary Fund offering a combined 177 billion euros to rescue Greece and Ireland this year. ECB President Jean-Claude Trichet, who signaled on Nov. 30 that investors are underestimating policy makers’ determination to shore up the stability of member nations, said in Paris last week that euro- area governments need a “quasi” fiscal union.
While this year’s test required 91 of Europe’s largest banks to provide regulators with the amount of sovereign debt on their books, not all nations and banks interpreted the test’s requests and published the data in the same way, Hahn said.
The exercise, intended to measure banks’ resilience in the event of a shrinking economy and a drop in government bond values, didn’t consider what would happen if a nation defaulted. Instead, the scenarios included the downgrading of securitized debt products by credit-rating companies, a 20 percent fall in the value of European equities, declines in real estate prices and 50 other macroeconomic parameters.
The tests were criticized by some for not being stringent enough. Regulators said the banks needed only 3.5 billion euros of new capital, about a 10th of the lowest analyst estimate. Nomura Holdings Inc. said European banks would need to raise 30 billion euros, while Barclays Capital said they’d need as much as 85 billion euros.
The tests were “really scary,” Kenneth Rogoff, a Harvard University economics professor and former chief economist at the IMF, said in a Bloomberg Television interview on Dec. 6. “We were told everybody is fine; there is nothing to worry about. Now their credibility is less than ever.”
Seven lenders, including Germany’s Hypo Real Estate Holding AG, Agricultural Bank of Greece SA and five Spanish savings banks failed the EU tests.
Bank of Ireland Plc, the nation’s largest lender, and Allied Irish Banks Plc, the second-biggest, both based in Dublin, were deemed to have enough capital to pass the exams. When Ireland agreed to accept a 67.5 billion-euro aid package on Nov. 28, its central bank directed Allied Irish to raise 5.3 billion euros of additional capital. Bank of Ireland was told to raise 2.2 billion euros.
“The tests didn’t trigger the recapitalizations of enough banks to restore faith in the strength of the European financial system,” Veron said. “In the EU, there is the element of competition among member states. Any country that restructures its banking system without the neighbors doing the same runs the risk that parts of its banking industry would be acquired by the neighbors, with no reciprocity.”
By contrast, the U.S. test results, published in May 2009, determined that 10 banks, including Bank of America Corp. and Citigroup, needed to raise a total of $74.6 billion in capital. The lenders raised almost $100 billion by the end of that month.
The U.S. test was more successful in part because it didn’t require international cooperation, said J. Christopher Flowers, the former Goldman Sachs partner who leads New York-based leveraged buyout firm J.C. Flowers & Co.
“The U.S. is a more uniform market; it’s one nation,” Flowers said in an interview. “The difference between California and New York is not nearly as big as the difference between Portugal and Austria.”
National bank governors and regulators are reluctant to cede supervisory authority over banks to the ECB after nations from Italy to Belgium gave up their power to set monetary policy when they adopted the euro, Veron said. He has argued for the creation of a temporary cross-border organization to resolve Europe’s current banking crisis.
When European leaders announced the creation of the European Banking Authority in June 2009, they didn’t give it the power to transfer funds among national banking systems if they needed to recapitalize, Veron said.
A year later, the decision to publish the stress-test results required a summit of national leaders after Spanish government officials unexpectedly pledged to release data on individual banks.
“Spain said it would publish its results, and that forced other nations to follow suit,” Hahn said. “As soon as the political side got involved, though, people had to question what information would come out, as it became a political exercise rather than a regulatory exercise.”
With the EU providing bailouts to Greece and Ireland, it needs to play a more forceful role in monitoring the banks that finance those economies, according to Barbara Matthews, managing director of BCM International Regulatory Analytics LLC, a Washington-based company that advises on financial regulation.
“Policy makers have to be far more ambitious in their definitions of what constitutes a stress scenario based on what we’re living through this year,” said Matthews, who is a former U.S. Treasury attache to the EU. “Why even wait until 2011 to do a new stress test? The banks are going through the stress test as we speak.”
Carlos Egea, a London-based Morgan Stanley credit strategist, said banks should give a transparent and uniform breakdown of assets, including loans to companies and individuals by geography.
“The key benchmark for stress-test success is for investors to have enough transparency to be able to convincingly back-test them on their own,” Egea said.
The development of pan-European financial supervisory authorities isn’t complete, Egea said.
“The argument against a European banking supervisor was that, given that the fiscal cost of rescuing banks was domestic, it was fair that bank supervision should remain domestic too,” Egea said. “Given the contagion risks and the use of the European Financial Stability Facility funds to rescue the Irish banks, it is apparent that the true cost of any bank failure extends well beyond national borders and is a common and serious problem for the EU and especially the euro area.”
Lenders’ liquidity should be examined in the next round of stress tests in the wake of the EU’s fiscal crisis, Olli Rehn, the region’s economic and monetary affairs commissioner said yesterday.
“A liquidity assessment needs to be included in the future stress tests,” Rehn told reporters in Brussels.
Greek banks had the biggest amount of Greek, Irish and Portuguese debt, with holdings of 62 billion euros, followed by German banks with 44 billion euros and French institutions with 19 billion euros, according to a Nov. 29 Goldman Sachs report.
Hypo Real Estate Bank, which failed its stress test, has 21.9 billion euros of such debt, the most among its European peers, the report said. National Bank of Greece SA, which passed the test, has 19.8 billion euros, and Edinburgh-based RBS has 8.2 billion euros at risk.
While Jonathan Faull, the European Commission’s director general of financial services, said the next round of stress tests will be “demanding,” CEBS, the group that is weighing changes, may not include sovereign risk in its metrics.
It isn’t “clear that a repeat of the sovereign risk sensitivity analysis will be necessary in 2011,” the committee’s secretariat wrote in a Nov. 23 evaluation of the stress test obtained by Bloomberg News.
Avoiding stringent testing won’t help nations and banks regain market confidence, Cass Business School’s Hahn said.
“A market-accepted stress test would help move the pendulum” away from a focus on the solvency of nations, he said.
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