Who's Afraid of a Stress Test?

The region may still be too much on the edge of crisis to handle the truth
Illustration by Bloomberg View

On Oct. 26 the European Central Bank released the results of new stress tests on European Union banks, hoping to convince financial markets that the banking system is strong enough to weather another crisis. The latest exercise is an improvement over previous ones, which were derided as too soft—but it’s still not good enough.

The test had two parts. The first was a detailed examination of loans, to see whether they were worth what the banks said. This found that most of the 130 banks under review had overvalued their assets—by a total of €47.5 billion ($60 billion) at the end of last year. The second part asked, with assets correctly valued, whether the banks had enough capital to endure another recession and financial-market shock. It found that 25 did not, and eight of those need to raise an additional €6.4 billion in capital.

This closer scrutiny has helped. Deutsche Bank raised €8.5 billion in equity this year to boost its chances of passing. Weak institutions, such as Portugal’s Banco Espirito Santo and Austria’s Volksbanken network, are restructuring or shutting down. By strengthening the system and increasing confidence in it, the ECB’s tests might reverse a two-year slump in private-sector lending. That’s the hope, anyway.

Trouble is, the new tests were still pretty soft. Economists at Switzerland’s Center for Risk Management at Lausanne, for example, put the capital shortfall for just 37 banks at almost €500 billion, as opposed to the roughly €6 billion reported by the ECB for its sample of 130. This more stringent test mimics how the market value of equity behaves under stress.

The ECB, which becomes the euro area’s supranational bank supervisor on Nov. 4, should be strict. But it knew that if it were too tough, the blow to confidence could have plunged the EU, already in a stalled recovery and on the brink of deflation, back into crisis.

So the design of the exercise was compromised. It used a measure of capital that relies on banks to weight assets by risk—an opportunity to fudge the numbers. It ignored the credit freezes, forced asset sales, and contagion that can cause huge losses in bad times. The worst-case scenario projected a fall in euro-area output of just 1.4 percent in 2015 (in 2009, it dropped 4.5 percent). And no governments default.

Most worrying is that the euro area is still poorly equipped to handle a new crisis. Many governments lack the fiscal capacity to recapitalize failing banks. Europe’s new banking union—intended to break the link between the finances of banks and national governments—will have only €55 billion in its rescue fund. And there’s scant agreement on how the burden of fighting the next financial crash should be shared.

The new tests are a step forward. They won’t dispel the fear that’s hanging over the region’s banking system and economy.

Before it's here, it's on the Bloomberg Terminal.