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Ignored Greek Default Risk Makes Bank Stress Tests ‘Irrelevant’

Ignored Greek Default Risk Makes Bank Tests Irrelevant'
Greek Presidential guards march in front of the tomb of the Unknown Soldier outside the Greek parliament building in Athens. Photographer: Kostas Tsironis/Bloomberg

European Union stress tests on the region’s banks are becoming “irrelevant” because they ignore the possibility of a default by Greece.

“Everybody is so concerned about Greece defaulting and the effect that’s going to have on banks, yet that’s not something even being considered as part of the stress tests,” said Jane Coffey, head of U.K. equities at Royal London Asset Management, which manages about $51 billion. “Greece defaulting isn’t exactly a black swan event. There’s a very good chance it will happen.”

The cost of insuring Greek government debt against the risk of default surged to a record yesterday as concern mounted that policy makers will struggle to stop the crisis. Credit-default swaps indicate an 82 percent chance Greece will fail to meet its commitments within five years, according to CMA prices. The cost of insuring Irish and Portuguese government bonds also hit records this week, driving a gauge of European bank bond risk to the highest level since January.

The European Banking Authority, set up by the European Union last year to oversee the tests, won’t include a Greek default in the scenarios in the second annual assessment of banks’ resilience to economic shocks. European bank stocks have fallen 12 percent since last year’s tests, led by the EBA’s predecessor. Allied Irish Banks Plc, which passed those tests, later required a taxpayer bailout.

“The stress tests have lost all credibility and look like a complete waste of time for all involved,” said Lex van Dam, a London-based fund manager at Hampstead Capital LLP, which oversees about $500 million. “They are totally irrelevant.”

Sovereign Default

The EBA can’t include a sovereign default in the stress tests because that would lend credence to the possibility of such an event happening and undermine confidence in the region, said Richard Reid, an economist at the London-based International Centre for Financial Regulation.

Credit-default swaps on Greece soared 435 basis points to 2,189 yesterday, Ireland rose 37 basis points to 799, and Portugal climbed 21 basis points to 806. The average cost of insuring the debt of 13 of Europe’s biggest banks surged 6 basis points to 163, the highest since Jan. 14.

“Politically it’s very difficult for the EBA to assume a sovereign restructuring,” said Richard Barnes, the primary credit analyst for European banks at Standard & Poor’s Ratings Service. “But by requiring the banks to publish their sovereign exposures, investors and other market participants are given the means to adjust the stress-test results however they like.”

‘More Important’

Officials at the EBA didn’t respond to requests for comment. The London-based regulator has said it has toughened the tests after criticism that last year’s weren’t stringent enough. The disclosure of banks’ bond holdings by country will allow analysts to model their own scenarios.

The watchdog will also “check what banks are doing with reference to some sovereign exposures and see whether they’re taking a conservative attitude” when valuing the assets, Enria said in an interview in April.

“We want more certainty on what exposures are, and for a lot of the banks the last disclosure is from the stress tests last year,” said Philip Richards, a banking analyst at Societe Generale SA. “Everything that’s going on and might happen in Greece makes the stress test more important and not less.”

French Banks Cut

German lenders were the biggest foreign owners of Greek government bonds with $22.7 billion in holdings last year, the Bank for International Settlements said last month. French banks were second with $15 billion. At the end of 2010, Greek bonds held by banks in countries reporting to the BIS totalled $54.2 billion, of which 96 percent was owned by European lenders.

BNP Paribas SA, France’s biggest bank, Societe Generale and Credit Agricole SA may have their credit ratings cut because of their investments in Greece, Moody’s Investors Service said this week.

The EBA, led by former Italian banking supervisor Andrea Enria, has been carrying out the tests since April, and may publish the results in July. A date for publication hasn’t been set formally because the EBA has said it must ensure it is satisfied with the quality of submissions from the banks.

Ninety-one banks will be expected to maintain a Core Tier 1 capital ratio of at least 5 percent under the stress-test scenarios, the EBA said. That capital measure is stricter than last year’s assessment, which had a pass rate of 6 percent Tier 1 capital, a measure of financial strength that encompasses a broader range of securities.

‘Main Weakness’

This year’s exams will test banks’ resilience to a 0.5 percent economic contraction in the euro area, a 15 percent drop in equity markets and a 125 basis point jump in short-term inter-bank financing costs.

“The main weakness is that the stress scenario in absolute terms is milder than what we do when we’re doing similar exercises,” said Richard Barnes, the primary credit analyst for European banks at Standard & Poor’s Ratings Service.

S&P’s own stress test, published in March, found European banks would need as much as 250 billion euros ($354 billion) in fresh capital if faced with a “sharp” increase in yields and a “severe” economic downturn. In contrast, a survey of 113 investors by Goldman Sachs Group Inc. published last week showed they expect banks to raise 29 billion euros after the tests.

‘Taking Them Seriously’

Last year’s tests were criticized for not being tough enough because lenders in the 27-nation region were shown by regulators to need only 3.5 billion euros of additional capital, about a 10th of the lowest analyst estimate.

“This feels very similar to last year when the Irish banks passed the stress tests and then duly collapsed,” said Bruce Packard, a banks analyst at Seymour Pierce in London. “It is difficult to see who exactly they are for, but I see little evidence that the buy-side is taking them seriously.”

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