When No. 1 Financial-Strength Ranking Spells Doom: Jonathan Weil

Less than three months ago the European Banking Authority said Dexia SA had passed its so-called stress test with ease. The French-Belgian lender’s July 15 news release carried this headline: “2011 EU-wide Stress Test Results: No Need for Dexia to Raise Additional Capital.”

Then last weekend, 86 days after getting its clean bill of health, Dexia took a government bailout to avoid collapsing. Nobody was surprised this happened. Nor should anyone have been.

The stress-test exercise was a charade, just as it was a year earlier when Bank of Ireland Plc and Allied Irish Banks Plc passed their tests and collapsed soon after. Once again the rules were rigged so only a handful of unimportant banks would flunk. Everyone who was paying attention understood this.

The European Union’s banking authority went through with the farce anyway, presumably aware that in all likelihood some big bank was bound to get a passing grade and quickly implode, the same as last year, causing embarrassment for everyone involved. All of which leads to the important question: Why?

Why would any self-respecting regulator participate in this sort of reputational suicide? Is the problem mass corruption? Is it mass stupidity? Assuming it’s both, where on the stupidity-corruption continuum does one begin and the other end? Whatever the case, the European Banking Authority is making even U.S. regulators look good. That’s no small feat.

Balance Sheet Star

Consider Dexia’s balance sheet as of Dec. 31, which is the date the banking authority used for its tests of 90 banks in 21 EU countries. Dexia’s tangible common shareholder equity was 6.7 billion euros, compared with 564.5 billion euros of tangible assets. (Both figures exclude goodwill and other intangible assets.) That gave it a 1.18 percent ratio, meaning Dexia had little hard capital available to absorb future losses.

Dexia nonetheless managed to show a capital ratio of 12.1 percent, based in part on its calculation that it had 17 billion euros of what the regulators call core Tier 1 capital. Dexia pointed to this figure in its latest annual report as proof that it “enjoys robust solvency.”

Dexia got that ratio mainly by excluding the bulk of its assets -- a process speciously referred to as risk-weighting -- along with billions of euros of pent-up losses on soured holdings such as Greek government bonds. The denominator in the ratio got smaller, the numerator got bigger, and Dexia wound up looking like one of Europe’s safest banks.

‘Adverse Scenario’

Using Dexia’s regulatory math as a starting point, the European Banking Authority then generously estimated Dexia’s core Tier 1 ratio would fall to 10.4 percent in 2012 under the “adverse scenario” it contemplated. The details of the scenario don’t matter now because Dexia is toast.

The takeaway here is you can’t believe anything about regulatory capital benchmarks, in Europe or elsewhere, stressed or not. (Citigroup Inc. was classified as “well capitalized” in late 2008 when it got its second U.S. bailout.) It’s a lesson the world should have learned long ago, yet keeps relearning.

In a way, by blowing its job so spectacularly, the European Banking Authority may have done the public a favor. Now that we have a clear point of reference, all you need to do to see what other European banks we should be worried about is look up which ones were sporting capital ratios similar to Dexia’s.

For instance, as of Dec. 31, four other European banks that passed this year’s stress tests had Tier 1 capital ratios of more than 10 percent while showing tangible common equity ratios of less than 2 percent, according to data compiled by Bloomberg. France’s Credit Agricole SA was one. The others were Germany’s Commerzbank AG, Landesbank Berlin AG and Deutsche Bank AG.

On Top

Alternatively, if you want a larger sample, click here for a chart the Italian bank Intesa Sanpaolo SpA showed at an Oct. 6 investor meeting in London, comparing its stress-test results with those of 20 of its peers. (This was one day after news broke that government intervention at Dexia was imminent.) Touting its fourth-place finish, Intesa said its “core Tier 1 ranks among the best under the adverse scenario.” And who was No. 1? Dexia, of course. So at least we can thank Intesa for the warning should the rest of Europe’s banks crater.

Bottom line, if Europe’s leaders want to further undermine public confidence in the region’s banks, then they should keep doing exactly what they’ve been doing the past couple of years. A few more put-ons like the last two rounds of stress tests and we’ll have the global financial crisis back to peak form in no time. Dexia’s demise is only the start.

(Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own.)